The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 10, May 2001, Panel Publishers, New York, NY.


By Robert W. Wood

It may be overly optimistic to give a comprehensive view of ISOs in a publication of this size (much less in one brief article). Still, there are a few fundamentals about ISOs that are worth noting, particularly inasmuch as they stand in rather stark contrast to the NSO rules. NSOs, as discussed in the preceding article, have almost a complete lack of restrictions.

ISOs must meet all of the following requirements:

Obviously, this is a fairly onerous and extensive list of requirements, particularly when one compares it to the almost nonexistent list of requirements for NSOs. Among other reasons, this lengthy list of potential footfalls is why ISOs can be a real pain in the neck. But, for those who are offered ISOs, the difference in tax treatment can be significant.

Basic Tax Treatment of ISOs

There is no tax when the company grants the ISO. There is also no tax (no regular income tax anyhow) when the ISO is exercised. This "no tax on grant, no tax on exercise" mantra has gotten a fair number of ISO participants in trouble. The not so hidden but sometimes surprisingly painful reason is the alternative minimum tax ("AMT"). There can be AMT when ISOs are exercised. The only regular tax possible with an ISO is when the underlying shares acquired pursuant to the option are sold. And, when these shares are sold, they can qualify for capital gain treatment (and assuming the long-term holding period is met, long-term capital gain). There is even a trick about this long-term capital gain (see "Sale of ISO Shares" below).

A word about the AMT. With a little luck, this could all change given the politics of tax legislation this year. Indeed, a few M&A Tax Report readers may remember that the entire individual AMT was expected to be repealed last year, something that unfortunately did not happen. The AMT can be a real mess to compute. Suffice it to say that the entire spread between the ISO exercise price and the fair market value of the underlying stock as of the date of exercise is considered a tax preference (translation: it goes into the AMT computation). Unless the employee exercises the ISOs and immediately sells the stock, the employee will get stuck with what may be a significant AMT liability.

Sale of ISO Shares

As if the ISO rules weren't complicated enough, it is important to clarify the above statement about long-term gain on sale of shares. You might think that long-term capital gain treatment would be assured if you exercise an ISO, wait a year and a day, and then sell your shares. As with just about everything else concerning ISOs, it's not quite that simple. There are two fundamental types of sales of shares acquired by an ISO.

The first is a "qualifying sale." As its name suggests, this is obviously the "good" kind of sale. The second is a "disqualifying sale," which carries an equally obvious moniker. The employee will recognize capital gain or loss if the sale is made in a qualifying sale, meaning two requirements must be met. The sale must be made at least two years after the date of grant, and one year after the shares are transferred to the employee (i.e., one year after the ISOs are exercised).

The sale is a disqualifying one if it is made within two years from the date of grant or within one year after the shares are transferred to the employee. Many an employee has received a grant of ISOs, exercised the options, held the stock for just over a year and then blithely sold it assuming it would receive long-term capital gain treatment. No go, if the sale of shares does not occur at least two years from the date the ISOs were granted. In this disqualifying sale, the spread upon exercise is treated as compensation income. The balance of the gain is long- or short-term capital gain, depending upon the holding period of the shares acquired.

Note especially the and/or conjunctions in the last few paragraphs. It is truly surprising how many ISO holders exercise and then unwittingly these disposition rules wrong (ouch!).

Treatment by Employer

It should come as no surprise that, for tax purposes, the employer is not entitled to an income tax deduction when the ISO is granted, or even when it is exercised. Indeed, the employer is not even entitled to a deduction when the employee sells the shares acquired on the exercise of an ISO in a qualifying disposition. A qualifying disposition is a good thing for an employee (because it imports capital gain treatment). But it is a bad thing for the employer (no tax deduction). From the employer's perspective, a disqualifying disposition (because it has compensation income, at least to a certain extent), will result in the employer becoming entitled to a tax deduction (for the amount of that compensation).

Accounting Treatment of ISOs

The accounting treatment of ISOs has been controversial. The basic accounting treatment of ISOs is one reason companies do not like ISOs (especially when they are trying to make their earnings for financial statement purposes look good (and what company doesn't?). The basic value of ISOs is a charge to earnings at the time the ISOs are granted, even though no tax deduction is available (and no compensation is actually treated as paid to the employee/ISO recipient) until the ISOs are exercised.

Tax and Accounting Treatment of ISOs, Vol. 9, No. 10, M&A Tax Report (May 2001), p. 1.