7546 / How is the grant of an incentive stock option taxed? How is the exercise of the option taxed?
No income is realized by the employee upon the grant of an incentive stock option. If the transfer of stock pursuant to the exercise of an incentive stock option is a qualifying transfer, no income will be realized by the employee at the time the option is exercised.1 The transfer will be a qualifying transfer if both of the following requirements are met:
(1) Holding period requirement: no disposition (defined below) of the stock may be made by the employee within two years of the date the option was granted, nor within one year of the date the stock was transferred pursuant to the option; and(2) Employment requirement: the transferee must be employed by the corporation granting the option (or its parent or subsidiary) at all times from the date the option was granted until three months before the date of exercise.2
If an employee becomes permanently and totally disabled, the three-month employment period is extended to 12 months.3 In the case of the death of an employee, the employment and holding requirements are waived.4
If an incentive stock option is exercised by an individual who does not meet the employment requirement described above (except in the event of the employee’s death), there will not be a qualifying transfer and the individual will recognize compensation income in the year the option is exercised. The amount of compensation income realized will be the excess, if any, of the fair market value of the stock over the exercise price of the option5 (see Q 7553 regarding disqualifying transfers).