Incentive Stock Options (ISOs)
A corporation may provide its employees with incentive stock options (ISOs) to acquire stock. For regular income tax purposes, ISOs meeting tax law tests (one-year and two-year holding periods) are not taxed when granted or exercised. Income or loss is not reported until you sell the stock acquired from exercising the ISO. To qualify as an ISO, the option must be exercisable within 10 years of the date it is granted and the option price must be at least equal to the fair market value of the stock when the option is granted.
Taxpayers should receive Form 3921 (or equivalent statement) from the corporation for the year they exercise an ISO. Form 3921 shows the dates on which the ISO was granted and exercised, the exercise price per share, the fair market value per share on the exercise date, and the number of shares acquired when the option was exercised. Form 3921 will help figure out the gain or loss when the stock is sold.
If the stock is held for more than one year after it was exercised and more than two years after it was granted, you have long-term capital gain or loss on the sale. The gain or loss is equal to the difference between the selling price of the stock and the option price you paid when the ISO was exercised. If you sell before meeting the one-year and two-year holding period tests, a gain on the sale is treated as part ordinary income (wages) and part capital gain.
For purposes of the alternative minimum tax (AMT), the excess of the fair market value of the stock at the time of exercise over the option price is treated as an adjustment that may substantially increase AMT income.
Employee Stock Purchase Plans (ESPPs)
Employee stock purchase plans (ESPPs) allow employees to buy their company’s stock, usually at a discount. The discount cannot exceed 15% and is considered ordinary income when the stock is sold. Options granted under ESPPs are not taxed until you sell the shares.
Taxpayers should receive Form 3922 (or equivalent statement) from the corporation the year they sell stock acquired at a discount under an ESPP. Form 3922 shows the date the option was granted, the date the option was exercised, the fair market value per share on the grant date, the fair market value per share on the exercise date, the exercise price per share, and the number of shares old.