Early Disposition of ISO Stock

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When you exercise a nonqualified option you have to report and pay tax on compensation income. You don't report compensation income when you exercise an incentive stock option — and if you hold the stock long enough, you'll never report compensation income from that stock. Of course, you'll have to report a capital gain if you sell the stock for a profit.

There's a catch. If you don't hold the stock long enough, you've made a disqualifying disposition. You'll have to report some or all of your gain as compensation income, which usually means paying a much higher rate of tax.

Special holding period

To avoid a disqualifying disposition you have to hold the stock you acquired by exercising your ISO beyond the later of the following two dates:

• One year after the date you exercised the ISO, or
• Two years after the date your employer granted the ISO to you.

Many employers don't permit exercise of an ISO within the first year after the employee receives it. If that's the case you don't have to worry about the holding more than two years after the date your employer granted the option.

If you hold the stock long enough to satisfy this special holding period, then any gain or loss you have on a sale of the stock will be long-term capital gain or loss. You won't be required to report any compensation income from the exercise of your option.

If you fail to satisfy the holding period described above, your sale or other disposition of the stock is considered a disqualifying disposition. In this case you'll have to report compensation income as described below.

Disqualifying dispositions

Everyone understands that a sale of the stock within the special holding period results in a disqualifying disposition. It's important to recognize that many other types of transfers can also result in a disqualifying disposition, for example:

• A gift to someone other than your spouse.
• Using your shares to exercise another incentive stock option.
• Transferring your shares to an irrevocable trust.

Certain events do not give rise to a disposition for purposes of these rules, however:

• A transfer that occurs as a result of your death.
• An exchange of shares that is part of a tax-free reorganization of the corporation that issued the shares (for example, certain mergers).
• A transfer that results from exercise of a conversion privilege (for example, converting preferred stock into common stock).
• A pledge or hypothecation (in other words, using the stock as collateral).
• A transfer that doesn't change the legal title of the shares (such as a transfer to a broker so the stock will be held in street name).
• A transfer of stock into joint tenancy (or a transfer out of joint tenancy, provided it goes back to the employee who exercised the ISO).

A transfer to a spouse (or to a former spouse in connection with a divorce) is a special case. This is not considered a disqualifying disposition. Following such a transfer, the transferee spouse is subject to the same tax treatment as would have applied to the transferor. The transferor spouse should provide records needed to determine when the special holding period will be satisfied, the cost basis of the shares and the value of the shares at the time the option was exercised.

Consequences of a disqualifying disposition

The tax consequences of a disqualifying disposition apply in the year the disposition occurs. You aren't supposed to go back and amend the return for the year you exercised the option, if that was an earlier year.

If your disqualifying disposition is a sale of your shares to an unrelated person without a "replacement purchase" (see below), your tax consequences are as follows:

• For a sale below the amount you paid for the shares, you don't report any compensation income. Your loss on this sale is reported as a capital loss.
• For a sale above the amount you paid for the shares but no higher than the value of the shares as of the date you exercised the option, report your gain on the sale as compensation income (not capital gain).
• If you sell your shares at a price that's higher than the value of the shares as of the date you exercised the option, you report two different items. The bargain element when you exercised the shares (the difference between the value of the shares as of that date and the amount you paid) is reported as compensation income. Any additional gain is reported as capital gain (which may be long-term or short-term depending on how long you held the stock).

If you had a disqualifying disposition from a transaction other than a sale to an unrelated person (such as a gift to someone other than your spouse, or a sale to a related person other than your spouse), or you bought replacement shares within 30 days before or after your sale, it's possible that the rules for that type of transfer don't permit the deduction of losses. If your disqualifying disposition comes from a type of transaction where a deduction for losses is not permitted, the following rules apply:

• You have to report the full amount of the bargain element from when you exercised the option as compensation income. That's true even if the value of the stock has gone down since the date you exercised the ISO.
• If the transaction requires you to report gain (such as a sale to a related person other than your spouse), any gain that exceeds the amount of compensation income should be reported as capital gain (which may be long-term or short-term depending on how long you held the stock).