Bargain element

The bargain element is measured on the exercise date, across all the shares you buy. IRS publications and instructions usually call the same amount the spread. In the IRS’s own example, 100 shares worth $25 each, bought at $10, give a bargain element of $1,500. The strike price and the exercise price are one number, so the bargain element is never the gap between them.

For an NSO, the bargain element is ordinary income in the year you exercise. For employees, it is wages on Form W-2, with code V in box 12. For an ISO, the bargain element is not regular income at exercise. It is added to your income for the alternative minimum tax (AMT) if you still hold the shares at year end. An ISO sale within 2 years of grant or 1 year of exercise makes the bargain element ordinary income, usually capped at your gain.

ESPP shares have their own holding periods: 2 years from the grant date and 1 year from purchase. A sale before both periods have ended makes the whole bargain element at purchase ordinary income. Unlike with ISOs, that income is not capped at your gain. If you sell after both periods end, the ordinary income is the smaller of your gain and the discount on the grant date.