incentive stock options for tax reporting

In your compensation package, your employer may offer you employee incentive stock options. If you find yourself presented with these, you may have questions about how and when to exercise them. Stock options can be an excellent tool for investing, as they can enable you to buy stock in the company for a discounted rate. Of course, stock options also bring some risk and potential tax consequences.

Stock options are not all equal. As such, you should understand your options and what may be right for you. This guide to incentive stock options will help you determine how to report them when filing your taxes.

What Is an Incentive Stock Option?

An incentive stock option, aka a qualified stock option, might be part of your compensation package if your company wants to reward you for your efforts. Your company can only offer you incentive stock options, and there are limitations on how many they can give you.

When your employer offers you stock options, they present you with the opportunity to purchase shares of company stock at a set price during a specific period. You still need to buy the stock, which distinguishes incentive stock options from restricted stock units.

You can buy a given number of shares of incentive stock options when they become available at the exercise price. Ideally, you will exercise your stock options before the stock’s price exceeds the exercise price. As such, it is crucial not to wait too long because incentive stock options have expiration dates. You could leave money on the table if you do not purchase your stocks before the exercise price expires.

How to Report Exercise of Incentive Stock Options

The first reportable tax event with incentive stock options happens when you exercise them. You will receive Form W-2, Form 1099-B, Form 3921 and Form 3922 when incentive stock options are part of your compensation.

  • Form W-2: Form W-2 is for reporting your compensation income, including short-term capital gains from your sale of the incentive stock option shares in the event you made a disqualifying disposition. Boxes 12 and 14 of this form include transactions related to your employee stock options.
  • Form 1099-B: Form 1099-B is for reporting capital gains or losses after you sell stock units. You may receive this form at the end of the year in which you sold your stocks. Since most incentive stock-related tax mistakes occur when the cost basis is inaccurate, you may want to make sure you review this form. If the cost basis you report on your Form 1099-B is not the same as your adjusted cost basis, you might need to make a tax modification.
  • Form 3921: After you exercise an incentive stock option, you will receive Form 3921 from your employer. On this form, you will report essential values and dates that are necessary to determine the correct amount of ordinary and capital income to report on your tax return. You will file this form every time you exercise an incentive stock option. You should receive the form the year you exercise the incentive stock option.
  • Form 3922: If you exercise your incentive stock option but decide to hold the stock, your employer will not include it as ordinary income on your Form W-2. That occurs because you didn’t yet sell the shares. For these stocks, your employer should issue Form 3922. As with Form 3921, when you sell your incentive stock options, Form 3922 becomes relevant.
taxes for qualifying dispositions

How Are Incentive Stock Options Taxed?

Are incentive stock options tax-deductible? Their requirements determine their taxability. You need to report incentive stock options for tax purposes at two different times – when you exercise them and when you sell them. Incentive stock options’ taxability when you sell them varies based on whether the sale meets the requirements of a qualifying disposition.

The IRS considers an incentive stock option income when you exercise it solely for calculating your alternative minimum tax. You must also report the sale of stock you acquire through incentive stock options for AMT purposes. An AMT calculation can quickly become complicated, so if you will be exercising an incentive stock option, you may want to speak with a tax advisor who can help you understand the implications on your tax bill.

On the day you exercise incentive stock options, the difference between the fair market value and the exercise price will count as income when calculating AMT. At the time of the sale, how you will be subject to taxation on your gains depends on how long you hold your shares. The amount of time you wait to sell the shares will determine whether you trigger a disqualifying or qualifying disposition.

Taxes for Qualifying Dispositions

Incentive stock options become so valuable due to the preferential tax treatment that results from triggering a qualifying disposition. If you initiate a qualifying disposition, profits you make from the stock’s sale will be taxable at the rate of long-term capital gains. Because income tax rates are higher than the rates for long-term capital gains, this is when you can enjoy the benefits of incentive stock options.

Taxes for Disqualifying Dispositions

If you do not fulfill the requirements for the waiting period to get a qualified disposition, you will have a disqualifying disposition. As a result, you will lose the tax advantage that comes with the long-term capital gains rate.

When you trigger a disqualifying disposition, the difference between the fair market value on the exercise date and exercise price will be eligible for taxation as regular income. Meanwhile, the difference between the fair market value on the sale date and exercise date counts as a capital gain.

You will pay a rate based on whether your capital gain is short- or long-term. Whether you qualify for a short- or long-term capital gain depends on how long you hold the stock before the sale. Short-term capital gains count as ordinary income for tax purposes, so long-term capital gains are more favorable.

Contact the Tax Professionals at SD Mayer & Associates

At SD Mayer, we serve clients across the country, though our home base is in San Francisco, the city of entrepreneurship and innovation. Since we are in the hub of technical expertise and creativity, we can stay abreast of the latest technology and serve you better.

When you work hard for your money, it should work hard for you. We can help you with accounting for incentive stock options, and we can optimize your compensation while protecting you from an unnecessary tax burden. If you are a business employee or executive who holds company stock, contact us at SD Mayer today to learn more about tax treatment for incentive stock options and the services we offer.

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