ISO Sell-to-Cover: Tax at Exercise vs. When You Sell

Someone on Reddit was exercising Incentive Stock Options (ISOs) using sell-to-cover (1,000 shares, grant price $50, market at exercise $120) and wanted a sanity check: (1) Will they be taxed on capital gains of $70,000 at exercise? (2) Is cost basis for the shares they keep $120 so that selling at $150 means $30 gain per share? For ISOs, you are not taxed on the spread as regular income at exercise; there is no regular income at exercise. The $70,000 spread (1,000 × ($120 minus $50)) is an AMT preference item, so you may owe AMT that year. Cost basis and gain when you sell depend on qualifying vs. disqualifying disposition: qualifying (hold 2 years from grant, 1 year from exercise) = basis $50, gain $100 per share at $150; disqualifying = basis can be $120, additional gain $30 per share at $150.

Bottom line: At exercise: You are not taxed on $70,000 as regular income when you exercise ISOs and hold the shares. The $70,000 spread is an AMT preference item; you may owe AMT (or more AMT) that year. Sell-to-cover only means you sold some shares to pay the exercise cost (and possibly estimated tax); it does not change ISO tax treatment. When you sell the shares you kept: Qualifying disposition (hold at least 2 years from grant and 1 year from exercise): for regular tax, cost basis = exercise price ($50); gain when you sell at $150 = $100 per share (long-term capital gain). Your understanding that basis is $120 and gain is $30 per share is not correct for a qualifying ISO disposition. Disqualifying disposition (sell before meeting the holding period): the spread at exercise can be compensation income; basis can be $120 (FMV at exercise); additional gain when you sell at $150 = $30 per share. For your specific grant, exercise, and planned sale dates, consult a tax professional. Margen can help you model AMT and gain on sale.

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Question from Reddit

Tax implications of ISO's exercised as "sell to cover"

A sanity check for me. Usually I just do a cashless exercise. This time I'm thinking about sell-to-cover and just hold onto the shares. My understanding is the taxes will work something like this.. I'll just use round numbers...

1000 Shares

Grant price - $50

Market Price at time of exercise - $120

I will be taxed based on capital gains of $70,000.

In the future, when I sell the acquired shares, my cost basis will be $120 per share for tax purposes. So, in a few years if I sell for $150, my gain is $30 per share.

Source: Reddit

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Analysis

The user is exercising ISOs with sell-to-cover (selling enough shares to cover the exercise cost and taxes, then holding the rest). They want to confirm: (1) Whether they are taxed on $70,000 (the spread: 1,000 × ($120 minus $50)) at exercise; and (2) Whether cost basis for the shares they keep is $120 so that a future sale at $150 produces $30 gain per share. For ISOs, exercise generally does not trigger regular income tax if you hold the shares, but the spread does affect Alternative Minimum Tax (AMT). Cost basis and gain on future sale depend on whether the sale is a qualifying or disqualifying disposition.

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Answer

At exercise

You are not taxed on $70,000 as regular income when you exercise ISOs and hold the shares. There is no regular income at exercise for ISOs. The $70,000 spread (1,000 × ($120 minus $50)) is, however, an AMT preference item; it is included in your alternative minimum taxable income for the year of exercise. So you may owe AMT (or more AMT) that year even though you have no regular tax on the exercise. Sell-to-cover only means you sold some shares to pay the exercise cost (and possibly estimated tax); it does not change the fact that the exercise itself is not regular taxable income for ISOs.

When you sell the shares you kept

Your cost basis and gain depend on how long you hold and whether the sale is a qualifying or disqualifying disposition.

• Qualifying disposition (you hold the shares at least 2 years from the grant date and 1 year from the exercise date): For regular tax, your cost basis is the amount you paid, the exercise price ($50 per share). So when you sell at $150, your gain for regular tax is $150 minus $50 = $100 per share (long-term capital gain). Your understanding that basis is $120 and gain is $30 per share is not correct for a qualifying ISO disposition; for that, basis is $50, so gain is $100 per share.
• Disqualifying disposition (you sell before meeting the 2-year / 1-year holding period): The spread at exercise ($70 per share) is generally compensation income (ordinary income) in the year of exercise (or the year of sale, depending on timing), and your cost basis for the shares can be $120 (FMV at exercise). So when you sell at $150, the additional gain for regular tax is $150 minus $120 = $30 per share (capital gain). That matches your $30 per share number, so your numbers fit a disqualifying disposition (or nonqualified options, where basis = FMV at exercise).

Summary

• Exercise: No regular tax on the spread; AMT can apply on the $70,000 spread.
• Future sale (qualifying): Basis = $50 (exercise price), gain = $100 per share when you sell at $150 (LTCG).
• Future sale (disqualifying or NQSO-style): Basis = $120 (FMV at exercise), additional gain = $30 per share when you sell at $150.

Practical notes

• If your income in the year you exercise pushes you into AMT, the $70,000 spread will increase your AMT; estimate AMT before exercising so you're not surprised.
• Sell-to-cover does not change ISO tax treatment; it just pays for the exercise (and possibly tax) by selling some shares.
• Margen can help you model AMT in the year of exercise and capital gain when you sell, for both qualifying and disqualifying scenarios.
• Consult a tax professional for your specific facts (grant date, exercise date, planned sale date) so you know whether you're on track for a qualifying disposition and how much AMT to expect.

Related: What Do I Do with Form 3921? Where to Enter ISO Exercise in Tax Software · Can You Reduce ISO Tax via a Trust? Revocable vs. Living Trust · Form 83(b) Restricted Stock Election · TurboTax ISO Disqualifying Disposition, W-2 Cost Basis

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Applicable Sections

Federal / IRS

• IRC § 422: Incentive Stock Options; no regular income at exercise if you hold the shares; the spread is an AMT preference (IRC § 56(b)(3)).
• Qualifying vs. disqualifying disposition: Qualifying: Hold 2 years from grant and 1 year from exercise; gain from exercise price to sale price is long-term capital gain; basis for regular tax = exercise price. Disqualifying: Sale before that; spread at exercise can be compensation income; basis can be FMV at exercise.
• Publication 525: Taxable and Nontaxable Income; discusses stock options, including ISOs and AMT. (IRS Publication 525)

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Practical Notes

• ISO exercise: No regular income at exercise; AMT on the spread ($70,000 in your example).
• Qualifying disposition: Basis = exercise price ($50); gain when you sell at $150 = $100/share (LTCG).
• Disqualifying disposition: Spread can be compensation; basis = FMV at exercise ($120); additional gain when you sell at $150 = $30/share.
• Sell-to-cover = way to pay for exercise; does not change ISO tax rules.
• Margen can help you model AMT and gain on sale for different hold/sale dates.
• Consult a tax pro to confirm qualifying vs. disqualifying and AMT for your situation.

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Limitations

This answer assumes federal rules and standard ISO treatment; state tax and employer plan details can differ. For AMT, holding periods, and basis for your exact grant/exercise/sale dates, consult a tax advisor. Margen can help you model exercise and sale scenarios before you act.