It’s important to understand the tax rules on selling ISO shares. Incentive Stock Options are a type of employer stock option that provides potential tax benefits under the U.S. Internal Revenue Code. Unlike non-qualified stock options (NSOs), ISOs are only available to employees, not to board members or consultants.

Favorable Tax Treatment

To qualify for favorable tax treatment on ISOs, you must hold the shares for at least two years after the grant date, and at least one year after exercising the options. Meeting both criteria results in what’s known as a qualifying disposition, where profit on the sale is taxed as a long-term capital gain. Qualifying for long term capital gains tax treatment means you could pay much less in taxes, compared to the taxes you pay at ordinary income tax rates.

Selling ISO Shares at a Gain

Now, suppose you are selling ISO shares at a gain, meaning the current stock price is higher than the exercise price. Let’s assume you met the required holding periods and this is a qualified disposition.

In this case, the difference between the exercise price and the higher sale price is treated as a long-term capital gain. This is where the benefit of ISOs come int play, because long-term capital gains are taxed at preferential rates, generally 15% or 20%, depending on your income level. This is the most tax-efficient scenario for any type of stock option and the main reason why many employees choose to hold onto their ISO shares beyond the required holding periods, despite the risk of price fluctuations.

Selling ISO Shares at a Loss

What happens when you sell ISO shares at a loss? Let’s assume you exercised your ISOs, held the stock for more than two years after the grant and one year after exercise, but later sold the shares at a price lower than your exercise price.

Here’s what happens:

• You incur a capital loss on the transaction.
• This loss can be used to offset capital gains from other investments.
• If your losses exceed your gains, you can deduct up to $3,000 against ordinary income each year and unused losses can be carried forward to future tax years.

Selling ISO Shares Before Holding Period

If you are planning on selling ISO shares before meeting the required holding periods, this will be a disqualifying disposition. This happens when you sell the ISO shares before holding them for one year after exercise and two years after the grant date.

This is not an ideal situation from a tax perspective because the difference between the exercise price and the fair market value (FMV) at exercise will be taxed as ordinary income. In addition, if the stock price increased after exercising, any gain between the FMV at exercise and the actual sale price is taxed as a capital gain. This scenario can lead to higher tax liability, but sometimes employees choose this route for liquidity or risk-management reasons.

Alternative Minimum Tax and Exercising ISOs

When you exercise ISOs, there is no immediate regular income tax due, however, you may be subject to the Alternative Minimum Tax. For the purpose of calculating the Alternative Minimum Tax, the spread between the exercise price and the fair market value (FMV) at the time of exercise is considered income. This can result in AMT tax liability in the year you exercise, even if you don’t sell the stock.

Situations like this often times catch investors by surprise, because you may owe AMT tax without receiving any cash in the first place because you haven’t sold the shares. If the stock later drops below the exercise price, and is eventually sold at a loss, you may be eligible to claim an AMT credit in future years to help recover some of that tax. This is a key consideration when deciding whether to exercise and hold ISO shares, especially in volatile markets.

Because these scenarios can get complex, especially when combined with other sources of income and equity compensation like RSUs or NSOs, it’s wise to keep detailed records and work with a financial advisor or tax professional. For those navigating equity compensation, especially in high-growth industries, timing matters. A thoughtful strategy around exercising and selling ISO shares can significantly affect your overall tax liability and your long-term wealth.

If you’re ready to navigate the complex tax rules around selling ISO shares with clarity and confidence, Navalign Wealth Partners can help you make informed decisions that align with your goals.