How Are Stock Options Taxed When Exercised?

Employee stock options give you the right to purchase company shares at a fixed price, called the strike price, for a specific period. Exercising these options can be a significant part of your compensation, but understanding the tax rules is necessary to realize their full value.

Identifying Your Stock Option Type

To understand your tax obligation, you must first identify which type of stock option you have. There are two primary categories: Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). The tax treatment for each is considerably different, impacting the timing and character of your income.

NSOs are the more common type and can be granted to employees, directors, and consultants. In contrast, ISOs can only be granted to employees and have stricter rules, including a $100,000 annual limit on the value of options that can become exercisable. Any amount over this limit is treated as an NSO.

Your stock option grant agreement will explicitly state whether you have NSOs or ISOs. If you cannot locate this agreement, your company’s human resources or equity compensation department can confirm the type of options you hold.

Tax Treatment of Non-Qualified Stock Options (NSOs)

When NSOs are granted, there is no tax event. A tax liability is triggered only at exercise and the subsequent sale of the shares. The main tax event occurs at exercise, when you are taxed on the difference between the Fair Market Value (FMV) of the stock on the exercise date and the strike price you paid. This difference is the “bargain element” and is taxed as ordinary compensation income.

This income is subject to federal, state, Social Security, and Medicare (FICA) taxes, and your employer is required to handle the withholding. For example, if you exercise 1,000 NSOs at a $5 strike price when the stock’s FMV is $25, the bargain element is $20,000. This $20,000 is compensation included on your Form W-2 for that year.

Your employer will handle the required tax withholding, often through a “sell-to-cover” transaction where some shares are sold to pay the tax, or by requiring a cash payment from you. After exercising, your tax basis in the stock becomes its FMV on the exercise date.

Any future sale of these shares will result in a capital gain or loss calculated from this new basis. If you hold the shares for one year or less before selling, the gain is a short-term capital gain taxed at ordinary income rates. Holding the shares for more than one year results in a long-term capital gain, which is taxed at lower rates.

Tax Treatment of Incentive Stock Options (ISOs)

Similar to NSOs, there is no tax event when ISOs are granted. Exercising an ISO does not trigger any immediate income for regular tax purposes. This favorable treatment is a primary benefit of ISOs, but it has a major caveat related to the Alternative Minimum Tax (AMT).

While the bargain element is ignored for regular tax, it is an adjustment item for the AMT. This spread between the FMV at exercise and your strike price is added to your income for the AMT calculation and can trigger a tax liability.

The tax treatment upon selling shares acquired through an ISO depends on meeting specific holding period requirements. A “qualifying disposition” offers the best tax outcome, which requires selling the shares more than two years after the grant date AND more than one year after the exercise date. If both conditions are met, the entire gain between your final sale price and original strike price is taxed as a long-term capital gain.

If you fail to meet either holding period requirement, the sale is a “disqualifying disposition.” In this case, the bargain element at exercise is taxed as ordinary income in the year of the sale. Any additional appreciation from the exercise date to the sale date is treated as a capital gain.

Understanding the Alternative Minimum Tax (AMT)

The Alternative Minimum Tax (AMT) is a parallel tax system ensuring that certain taxpayers with high economic income pay a minimum amount of tax. Taxpayers must calculate their liability under both the regular and AMT systems and pay the higher amount. Exercising ISOs and holding the shares through the end of the calendar year is a common event that can trigger AMT liability.

The AMT is calculated at rates of 26% or 28%, depending on your income level. A feature of this system is the AMT credit. When you pay AMT from exercising ISOs, you may generate a credit for the amount paid.

This credit can be carried forward indefinitely and used in future years to reduce your regular tax liability when it is higher than your tentative minimum tax. This effectively treats the AMT paid as a prepayment of future taxes. The AMT is calculated and reported on Form 6251, Alternative Minimum Tax—Individuals, which is filed with your annual tax return.

How to Report Stock Option Transactions on Your Tax Return

To report stock option transactions, you will need documents from your employer and brokerage firm. For NSO exercises, the compensation income is included as wages in Box 1 of your Form W-2. Your employer also reports this in Box 12 with code “V.”

When you sell shares from either an NSO or ISO exercise, the sale is reported on Form 8949, Sales and Other Dispositions of Capital Assets, with totals carried to Schedule D, Capital Gains and Losses. When reporting the sale of NSO shares on Form 8949, your cost basis is the FMV on the exercise date. This includes the strike price plus the ordinary income you already recognized.

Your employer provides Form 3921, Exercise of an Incentive Stock Option, for the year you exercise ISOs. This form provides the details needed to complete Form 6251 and determine if you owe AMT. The cost basis for ISO shares also depends on the sale type.

For a qualifying disposition, the basis is your strike price. For a disqualifying disposition, part of your gain is ordinary income reported on your W-2, and you must adjust your cost basis on Form 8949.