For a refresher on incentive stock option terminology, please see the earlier post.
Let’s consider a case in which an ISO is exercised in one year and a disqualifying disposition is made in a different year:
On May 1, 2004, you received an ISO grant of 1000 shares with an exercise price of $10 and it vested immediately.
On January 1, 2005, you exercised the option and bought 1000 shares. The FMV of the stock that day was $35/share.
On January 3, 2006, you sold the stock for $45 per share.
In this case, you held the stock long enough to qualify for long-term capital gains treatment, but the sale was a disqualifying disposition because you sold the stock less than 24 months after the option was granted. As before, there could be AMT consequences on your 2005 return and you’d need to determine whether you owe AMT taxes in 2005 as a result of the additional $25,000 in AMT income.
In 2006, the sale results in both ordinary income and long-term capital gains. You must pay ordinary income tax on the lesser of (1) the spread between the exercise price and the stock’s fair market value (FMV), or (2) the difference between the sales price and the exercise price (this would apply if you sold the stock at a price that was less than the FMV on the day of the option exercise). In the example described, you owe ordinary income tax on the difference between the fair market value and the exercise price, $25,000 ($35,000 – $10,000); you owe long-term capital gains tax on the $10/share difference between the sale and exercise prices. If you had to pay AMT in 2005 as a consequence of the ISO exercise, a later year you might be able to recover some of the AMT paid. Note that the disqualifying disposition eliminated the ability to treat the full gain of $35/share as a long-term gain.
Finally, consider a case in which a disqualifying disposition is made in the same year as the ISO exercise:
On January 1, 2003, you receive an ISO grant of 1000 shares with an exercise price of $10 and it vests over three years.
On January 5, 2006, you exercise the option and buy 1000 shares. The FMV of the stock that day is $35/share.
On December 3, 2006, you sell the stock for $45 per share.
This disqualifying disposition means that the ISO price spread (difference between FMV and exercise price) does not have an impact on your AMT income in 2006. By making a disqualified disposition of the stock, you cause the option to be treated as if it had been a non-qualified stock option (NQSO). In 2006, you’d pay ordinary income tax on $25,000 (1000 shares times the difference between FMV and exercise prices) and short-term capital gains tax on $10,000. If the stock had instead sold for only $30/share, you’d owe ordinary income taxes on $20,000 ($30,000 – $10,000).
Here again, there are possibilities for tax planning. One can imagine a situation in which you might deliberately make a disqualifying disposition before the end of 2006. For example, if the ISO adjustment to your AMT income were large enough, you might find it desirable to avoid AMT and pay ordinary income tax on the stock sale profit. Or in another situation, if the stock price had declined precipitously in late 2006, you would risk paying AMT on a worthless stock. Making a disqualifying disposition before year-end would eliminate the additional 2006 AMT income from the ISO spread.
Since you lose property and state taxes as deductions under AMT, these also become factors in determining the best tax-minimization strategy when ISO stock is involved.
One caveat: if you make a disqualifying disposition after the stock price has declined following exercise but also purchase your company’s stock (for example, via an ESPP) within 30 days before or after the stock sale, this triggers the IRS “wash sale” rule: you are not permitted to deduct the realized loss, and the disallowed loss is added to the basis of the newly-purchased stock. If this happens, it may not be a disaster, but it does complicate the tax consequences of the sale; it should not be done unwittingly.
Stock option taxation rules are complex; what I’ve presented here is not an exhaustive discussion of the issues that you may need to consider when exercising stock options. The information contained in this article is not intended to replace personalized tax planning advice. You should consult a qualified tax planning professional before implementing tax-reduction strategies.