GroundSkill
Classify statutory stock-plan dispositions, bad debts, and trader status
Three property topics look alike but are taxed differently. A statutory option can sit silent for years and then split one sale into wages and gain. A loan to a friend can become a capital loss, but only when it is totally worthless. And a person who trades all day can still be an investor if the activity does not meet the trader tests. This lesson covers the holding-period rules, the worthlessness rule, and the trader tests.
A statutory stock option (an ISO or an employee stock purchase plan option) has no regular-tax effect at grant or exercise. For AMT, an ISO exercise is different: treat the stock as if no special treatment applied and include the FMV-minus-option-price adjustment when rights are transferable or no longer subject to a substantial risk of forfeiture, with no adjustment if the stock is disposed in the same year it is exercised, and increase AMT basis by the adjustment. The tax arrives at sale, and the holding period requirement decides its shape: hold until the later of 1 year after the shares reach the employee and 2 years after the grant, and the sale is capital (a discounted ESPP option still carves out a wage portion equal to the lesser of the grant-date discount and the gain at disposition, with any excess gain capital and any loss fully capital with no ordinary income). Sell early and the result splits by plan: a disqualifying ISO with a gain makes the exercise spread ordinary only up to the gain, with any excess capital; a disqualifying ISO at a loss produces only a capital loss with no ordinary income; a disqualifying discounted ESPP option makes the full exercise spread ordinary even beyond the gain. In each case basis steps up by the reported wages, so capital gain or loss is figured from the amount paid plus the reported wages.
| Sale | Ordinary portion | Rest |
|---|---|---|
| Qualifying ISO (clock met) | None | Capital gain or loss |
| Qualifying discounted ESPP (clock met) | Lesser of grant-date discount and disposition gain | Capital remainder; a loss is fully capital with no ordinary income |
| Disqualifying ISO with gain (clock failed) | Exercise spread, capped at the gain | Capital remainder |
| Disqualifying ISO at loss (clock failed) | None | Capital loss |
| Disqualifying discounted ESPP (clock failed) | Full exercise spread, even beyond the gain | Capital gain or loss from stepped-up basis |
An employee gets an ISO at $20, exercises at $30, and sells at $38 after holding more than 2 years from grant and more than 1 year from exercise. The whole $18 per-share gain is capital. Had she sold six months after exercise instead, $10 of each share would be ordinary wages and only the remaining $8 would be capital gain.
Publication 525 Page 12
Grant of option. If you receive a statutory stock option, don’t include any amount in your income when the option is granted.View on the source
Publication 525 Page 12
Exercise of option. If you exercise a statutory stock option, don’t include any amount in income when you exercise the option.View on the source
Publication 525 Page 12
Alternative minimum tax (AMT). For the AMT, you must treat stock acquired through the exercise of an ISO as if no special treatment applied. This means that, when your rights in the stock are transferable or no longer subject to a substantial risk of forfeiture, you must include as an adjustment in figuring alternative minimum taxable income the amount by which the FMV of the stock exceeds the option price. Enter this adjustment on Form 6251, line 2i. Increase your AMT basis in any stock you acquire by exercising the ISO by the amount of the adjustment. However, no adjustment is required if you dispose of the stock in the same year you exercise the option.View on the source
Publication 525 Page 12
Holding period requirement. You satisfy the holding period requirement if you don’t sell the stock until the end of the later of the 1-year period after the stock was transferred to you or the 2-year period after the option was granted.View on the source
Publication 525 Page 13
Holding period requirement not satisfied. If you don’t satisfy the holding period requirement, your ordinary income is the amount by which the stock’s FMV when you exercised the option exceeded the option price. This ordinary income isn’t limited to your gain from the sale of the stock. Increase your basis in the stock by the amount of this ordinary income. The difference between your increased basis and the selling price of the stock is a capital gain or loss.View on the source
Publication 525 Page 12
Holding period requirement not satisfied. If you sell stock acquired by exercising an ISO, don’t satisfy the holding period requirement, and have a gain from the sale, the gain is ordinary income up to the amount by which the stock’s FMV when you exercised the option exceeded the option price. Any excess gain is capital gain. If you have a loss from the sale, it’s a capital loss and you don’t have any ordinary income.View on the source
Publication 525 Page 12
Report the capital gain or loss as explained in the Instructions for Schedule D (Form 1040). In determining capital gain or loss, your basis is the amount you paid when you exercised the option plus the amount reported as wages.View on the source
Publication 525 Page 13
Option granted at a discount. If, at the time the option was granted, the option price per share was less than 100% (but not less than 85%) of the FMV of the share, and you dispose of the share after meeting the holding period requirement, or you die while owning the share, you must include in your income as compensation the lesser of: • The excess of the FMV of the share at the time the option was granted over the option price, or • The excess of the FMV of the share at the time of the disposition or death over the amount paid for the share under the option. For this purpose, if the option price wasn’t fixed or determinable at the time the option was granted, the option price is figured as if the option had been exercised at the time it was granted. Any excess gain is capital gain. If you have a loss from the sale, it’s a capital loss, and you don’t have any ordinary income.View on the source
An employee receives an incentive stock option (ISO) to buy 1,000 shares of stock for $10 a share. She exercises when the stock is worth $16 and later sells for $20, after holding more than 2 years from grant and more than 1 year from exercise. Which of the following is correct regarding the sale?
A nonbusiness bad debt is a genuine loan outside any trade or business: you must have basis in it — cash you lent or income you already reported — owed under a true creditor-debtor relationship, never a gift or unpaid salaries, wages, or fees with no basis. The deduction requires three conditions: the debt is totally worthless (partly worthless never qualifies), the year is the year worthlessness arrives, and collection efforts back the call. The result is a short-term capital loss on Form 8949, with a statement describing the debt, the debtor, the collection attempts, and why it is worthless.
A retiree lends $5,000 to a former coworker for medical bills, keeps the signed note, and writes twice demanding payment. The borrower declares bankruptcy with no assets and the debt is discharged this year. The retiree deducts a $5,000 short-term capital loss on Form 8949 with the required statement. Had $1,000 remained collectible, no deduction would be allowed yet.
Publication 550 Page 83
All other bad debts are nonbusiness bad debts and are deductible as short-term capital losses.View on the source
Publication 550 Page 83
Deductible nonbusiness bad debts. To be deductible, nonbusiness bad debts must be totally worthless. You cannot deduct a partly worthless nonbusiness debt.View on the source
Publication 550 Page 85
Deduct nonbusiness bad debts as short-term capital losses on Form 8949.View on the source
Publication 550 Page 84
Basis in bad debt required. To deduct a bad debt, you must have a basis in it—that is, you must have already included the amount in your income or loaned out your cash. For example, you cannot claim a bad debt deduction for court-ordered child support not paid to you by your former spouse. If you are a cash method taxpayer (most individuals are), you generally cannot take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items.View on the source
A taxpayer lends $10,000 of cash to a friend. At year-end the friend has repaid $2,000, promises to keep paying, and $4,000 of the balance looks uncollectible. Which of the following is correct for the current year?
A trader runs a business of profiting from short-term price movements rather than from dividends or long-run appreciation, trading substantially and continuously, judged by holding periods, frequency and size, livelihood dependence, and time devoted. Missing those tests leaves the taxpayer an investor, whatever the brokerage statements are called. Without the mark-to-market election, even a trader's gains stay capital on Form 8949 and Schedule D under the loss limits; the business shows only in the expenses, which move to Schedule C, and in the exemption of the gains from self-employment tax. With the section 475(f) mark-to-market election, all trading gains and losses are ordinary in Part II of Form 4797 instead. A wash-sale loss stays nondeductible unless it was incurred in the ordinary course of business as a dealer in stock or securities.
A former engineer trades most mornings, holds positions for hours, places 700 trades a year, and supports herself on the profits: a trader. Her $30,000 of gains go on Form 8949 and Schedule D, her $2,400 of data and platform fees go on Schedule C, and no self-employment tax touches the gains. Her brother, who buys index funds quarterly and holds for years, is an investor on the same markets.
Publication 550 Page 104
To be engaged in business as a trader in securities or commodities, you must meet all the following conditions. • You must seek to profit from daily market movements in the prices of securities or commodities and not from dividends, interest, or capital appreciation. • Your activity must be substantial. • You must carry on the activity with continuity and regularity.View on the source
Publication 550 Page 104
You must seek to profit from daily market movements in the prices of securities or commodities and not from dividends, interest, or capital appreciation.View on the source
Publication 550 Page 104
If your trading activities do not meet the above definition of a business, you are considered an investor, and not a trader.View on the source
Publication 550 Page 104
Transactions from trading activities result in capital gains and losses (unless a section 475(f) election has been made) and must be reported on Form 8949 and Schedule D (Form 1040), as appropriate.View on the source
Publication 550 Page 105
Interest expense and other investment expenses that an investor would deduct on Schedule A (Form 1040) are deducted by a trader on Schedule C (Form 1040), Profit or Loss From Business, if the expenses are from the trading business.View on the source
Publication 550 Page 105
Gains and losses from selling securities or commodities as a trader are not subject to self-employment tax.View on the source
Publication 550 Page 104
Typical holding periods for securities or commodities bought and sold. • The frequency and dollar amount of your trades during the year. • The extent to which you pursue the activity to produce income for a livelihood. • The amount of time you devote to the activity.View on the source
Publication 550 Page 104
Mark-to-market election made. If you made the section 475(f) mark-to-market election, you should report all gains and losses from trading as ordinary gains and losses in Part II of Form 4797, instead of as capital gains and losses on Form 8949 and Schedule D (Form 1040).View on the source
Publication 550 Page 86
You cannot deduct losses from sales or trades of stock or securities in a wash sale unless the loss was incurred in the ordinary course of your business as a dealer in stock or securities.View on the source
A day trader executes hundreds of short-term stock trades most weeks to profit from daily price swings. An engineer buys shares a few times a year and holds for long-term appreciation. Which of the following is correct regarding trader status?
The course asks you questions like these as you learn, brings back the ones you miss, and ends with full-length practice exams.
See the course Or take the free 12-question checkGroundSkill is independently produced and is not affiliated with or endorsed by the IRS. Sources last checked 2026-09-14. Exam preparation, not tax advice.