Question

12. Which of the following statements correctly describes the income tax rules for incentive stock options (ISOs)?

(A) When the ISO is granted, the employee has ordinary income equal to the fair market value of the option.

(B) When the ISO is exercised, the employee must report capital gain equal to the fair market value of the stock less the option price.

(C) If the shares are held for 2 years after the option was granted and 1 year after the exercise, the gain from the sale will be taxed as long-term capital gain.

(D) If the employee sells the shares 1 year after the option was granted and 2 years after exercise, the employee will have no taxable income.

Answer 1

Taxation of ISOS ISOs are eligible to receive more favorable tax treatment than any other type of employee stock purchase plan. This treatment is what sets these options apart from most other forms of share-based compensation. However, the employee must meet certain obligations in order to receive the tax benefit. There are two types of dispositions for ISOs: Qualifying Disposition: A sale of ISO stock made at least two years after the grant date and one year after the options were exercised. Both conditions must be met in order for the sale of stock to be classified in this manner. Disqualifying Disposition: A sale of ISO stock that does not meet the prescribed holding period requirements. An employee incurs no income tax at grant or on the exercise of an ISO (although the spread is a tax adjustment item for purposes of calculating altemative minimum tax) and the profit (if any) made on the sale of the shares is taxed as long-term capital gain. Conclusion: Option C