By Bill Bischoff

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If you play your cards right with Incentive Stock Options, or ISOs, you could protect a significant amount of your profit from the IRS, thanks to two important tax advantages. First of all, you don't have to pay taxes immediately when you exercise ISOs — as long as you don't sell the stock you receive. Second, while you will have to pay taxes when you sell, you can qualify for the 15% maximum rate on long-term capital gains (assuming the current capital gains rates apply in the year you sell).

As we discuss in the other piece, with nonqualified options, you must pay income tax on the spread between the exercise price and the market price in the year you exercise. Then, when you sell the stock, you pay a separate tax on the spread between the market price at exercise and the price you eventually sell it for.

With ISOs, all the taxes are paid when you sell the stock and it's all capital gains. The catch? This deal applies only if you sell the ISO shares more than two years after the option-grant date (the date you received the option) and more than one year after you actually bought the shares by exercising your ISO. (If you sell sooner than that on either front you have what the IRS calls a "disqualifying disposition" — more on that in a moment.)

Here's an example. On June 30, 2010, you receive an ISO giving you the right to purchase 100 shares of employer stock for $10 a share. You exercise on June 2, 2011, when the market price is $16. Your per-share basis is $10 (that's the exercise price). You then sell on Aug. 2, 2012, for $25 a share. The sale date is more than two years after the June 30, 2010, grant date and more than 12 months after the June 2, 2011, exercise date. Therefore, your entire $1,500 profit is treated as a long-term capital gain qualifying for the 15% maximum federal rate.

Now, what if you meet the above rules but sell your ISO shares at a price that's either below the market value on the exercise date or (even worse) below the exercise price? In this case, your basis in the shares is the exercise price, so when the sale price exceeds that number, you have a gain that qualifies for the 15% maximum rate. If your sale price is below the exercise price, you've got a long-term capital loss. Sorry about that.

Disqualifying Dispositions

If you don't follow the holding rules, the favorable tax treatment of ISOs disappears.

If you make what's called a "disqualifying disposition" by selling less than two years after the grant date or less than one year after the exercise date, some or all of your gain will now be taxed as ordinary income rather than at the lower capital-gains rate. The tax rate on the spread from the exercise price to the price at which you sell the stock will depend on your holding period (which begins on the day after the exercise date).

For example, say you make a disqualifying disposition by selling less than two years after the grant date, but you owned the shares for more than a year after the exercise date. In that case, you'd owe income tax on the spread from the exercise price to the market price, and then capital gains on the gain after you exercised.

Have we lost you? Don't worry too much. Our calculator takes care of all of this for you. It will tell you just how much you'll owe if you exercise your ISO today (including whether that means you make a disqualifying disposition). And if you already own shares from exercising your ISO, we'll tell you what tax liability you'd trigger by selling your shares (again, including if this means you'd trigger a disqualifying disposition). One thing — the calculator will ask you for your "estimated marginal tax rate." To calculate that, click here.

Also, one thing our calculator does not do is factor in the Alternative Minimum Tax, which is essentially an alternative tax system for unlucky taxpayers. To learn more about this, see our articles, "The Alternative Minimum Tax" and "Avoiding the AMT on ISOs."

Evaluating Shares Acquired by Exercising ISOs

Evaluating Your Unexercised ISOs