Rules for determining your basis and holding period for stock from incentive stock options.
This page explains how to determine your initial basis for stock you acquire when you exercise an incentive stock option (“ISO”). The discussion assumes you acquired stock by exercising the option and paying cash. (Different rules, not covered here, apply if you paid for the stock by surrendering shares of stock you previously owned.)
Note: This page is part of our general guide to buying and selling stock and deals only with the basis of your shares. A guide to tax issues involving nonqualified options and incentive stock options appears in our Guide to Compensation in Stock and Options and in our book, Consider Your Options.
Employers sometimes grant incentive stock options to their employees. These options receive a different tax treatment under the tax law than nonqualified options.
You’re not required to pay tax at the time you receive an incentive stock option. The tax consequences occur at the time you exercise the option and at the time you sell the stock.
You don’t report income at the time you exercise an incentive stock option, and your employer is not required to withhold. However, you must report an adjustment for purposes of the alternative minimum tax (“AMT”). The adjustment is equal to the amount you would have reported as income if the option was a nonqualified option. As a result, you may end up paying some tax when you exercise an incentive stock option. This tax should be less than the amount you would have paid if you exercised a nonqualified option instead. Also, you may receive a credit for this tax in a future year.
Determining Your Basis
If you make a disqualifying disposition of your ISO shares, any profit on the sale, up to the amount of the bargain element when you exercised the option, is treated as compensation income. When you figure your gain or loss on the sale, your basis includes the amount you paid for the shares plus the amount of compensation income you reported on the disqualifying disposition.
You can avoid making a disqualifying disposition if you hold the stock until the later of (a) more one year after you exercised the option, or (b) more than two years after the option was granted. In that case you will have a dual basis in your stock. For purposes of determining your regular tax, your initial basis will simply be the amount you paid for the stock when you exercised your option. But you have a different initial basis for purposes of the alternative minimum tax. Your AMT basis is the amount you paid for the stock increased by the amount of the AMT adjustment reported on exercise of the option.
Your holding period for the stock (used to determine whether you have a long-term gain when you sell the stock) begins on the day you exercise the option. You are not allowed to include the period of time when you held the option.