ISO Shares at Death: Same Tax Outcome as Regular Stock? Step-Up in Basis

Someone on Reddit asked about shares acquired by exercising Incentive Stock Options (ISOs) that have appreciated: Is the tax outcome when you die the same as if you had owned normally purchased shares in a taxable account? Specifically: Do beneficiaries have to pay tax on the bargain element (the spread at exercise), or is it treated the same as standard capital appreciation upon death? Yes. For federal income tax, the tax outcome at death for ISO shares you held until death is the same as for normally purchased shares: beneficiaries do not pay tax on the bargain element (or any other unrealized gain) at the time of inheritance. The shares get the same step-up in basis to fair market value at the date of death that applies to most inherited property.

Bottom line: Yes. For federal income tax purposes, the tax outcome at death for ISO shares you held until death is the same as for normally purchased shares in a taxable account: beneficiaries do not pay tax on the bargain element (or any other unrealized gain) at the time of inheritance. The shares are treated like other inherited property; step-up in basis applies. The beneficiary's cost basis is generally the FMV at the date of your death (or alternate valuation date). Any unrealized gain at your death (including the bargain element and appreciation after exercise) is not taxed at death. When beneficiaries sell, they are taxed only on appreciation after they inherit (sale price minus FMV at date of death). Estate tax is separate from income tax. For your specific situation (estate size, state rules, trust vs. direct inheritance), consult a tax or estate professional. Margen can help model gain on sale using the stepped-up basis.

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Question from Reddit

ISO shares and basis adjustment at death

If you own shares of a company as a result of exercising ISOs and those shares have appreciated, is the tax outcome when you die the same as if you had owned normally purchased shares in a taxable account? Specifically I'm curious whether your beneficiaries would still have to pay tax on the bargain element or it'd be treated the same as standard capital appreciation upon death.

Source: Reddit

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Analysis

The user wants to know whether ISO shares held until death are taxed the same as regular shares in a taxable account, in particular whether beneficiaries owe tax on the bargain element (the spread between exercise price and fair market value at exercise) at the time of inheritance, or whether the shares get the same step-up in basis that applies to most inherited property. Under federal tax rules, inherited property generally receives a step-up (or step-down) in basis to the fair market value at the date of death (or alternate valuation date), so unrealized gains (including the bargain element and any appreciation after exercise) are not taxed at death.

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Answer

Yes. For federal income tax purposes, the tax outcome at death for ISO shares you held until death is the same as for normally purchased shares in a taxable account: beneficiaries do not pay tax on the bargain element (or any other unrealized gain) at the time of inheritance. The shares are treated like other inherited property; step-up in basis applies.

Step-up in basis

• When you die, property you own (including stock from exercised ISOs) is generally inherited by your beneficiaries. For federal income tax, the beneficiary's cost basis in inherited property is usually the fair market value (FMV) of the property on the date of your death (or on an alternate valuation date, if elected for estate tax purposes). That is the step-up in basis (or step-down if the asset has gone down in value).
• So any unrealized gain that existed at your death, including the bargain element from the ISO exercise (exercise price vs. FMV at exercise) and any appreciation after exercise, is not taxed at death. The beneficiary's basis is FMV at date of death, so that prior gain is effectively wiped out for income tax when the beneficiary inherits.

Tax treatment for beneficiaries

• At inheritance: Beneficiaries do not pay income tax on the bargain element or on any unrealized capital appreciation at the time they receive the shares. There is no separate "tax on the bargain element" at death.
• When they sell: Beneficiaries are taxed only on appreciation that occurs after they inherit, i.e., the difference between the sale price and their basis (FMV at date of death). So the treatment is the same as for inherited shares that were bought normally in a taxable account: step-up at death, then tax on gain (or loss) from that new basis when sold.

Why it's the same

• The step-up in basis rule (IRC § 1014) applies to inherited property generally. It does not distinguish between shares that came from ISOs and shares that were purchased in a taxable account. So the bargain element and all pre-death appreciation are not taxed at death; the beneficiary's basis is FMV at date of death, and only post-death appreciation is taxed when they sell.

Practical notes

• Beneficiaries should keep records of the FMV at the date of death (e.g., from the estate, broker, or appraisal) so they can report the correct basis when they sell and avoid overpaying tax.
• Estate tax (federal or state) is separate from income tax; the value of the shares at death may still be included in the estate for estate tax purposes. This answer is about income tax and basis for the beneficiaries.
• Margen can help you or your beneficiaries model gain on sale using the stepped-up basis so you're prepared for tax when the shares are sold.
• Consult a tax or estate professional for your specific situation (e.g., estate size, state rules, trust vs. direct inheritance).

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

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Applicable Sections

Federal / IRS

• IRC § 1014: Basis of property acquired from a decedent; generally, the basis is the FMV at the date of death (or alternate valuation date). This step-up (or step-down) applies to inherited stock, including shares acquired from exercising ISOs. (See IRS Publication 551, Basis of Assets.)
• Publication 551: Explains basis of assets, including inherited property and the step-up in basis. (IRS Publication 551)

Estate tax

• Estate tax (federal and state) may apply to the value of the shares at death; that is separate from income tax and basis for beneficiaries. An estate attorney or tax advisor can address estate tax.

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Practical Notes

• At death: ISO shares get the same treatment as normally purchased shares: step-up in basis to FMV at date of death; no income tax on the bargain element or pre-death appreciation at inheritance.
• When beneficiaries sell: They are taxed only on gain from the stepped-up basis (sale price minus FMV at date of death).
• Records: Beneficiaries should keep the FMV at date of death for basis when they sell.
• Margen can help model gain on sale using the stepped-up basis.
• Estate tax is separate; consult an estate or tax professional for your situation.

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Limitations

This answer focuses on federal income tax and basis for inherited ISO shares; it does not cover estate tax, state inheritance or estate rules, or trust vs. direct inheritance. For estate planning, estate tax, and state law, consult a tax or estate professional. Margen can help you model gain when the inherited shares are sold.