Here's how it works: The option has a cost basis of $0 on, eg, 100shrs. It is exercised at a pps of $8, which means a cap gain of $800 is incurred. It is now converted to 100 shrs shares with a cost basis of $8. The disposition generates the cash that covers the cap gains tax, say 30%, so 30 shares are sold immediately at no additional cap gains and the proceeds pay the cap gains tax. This is why option exercises are always accompanied wby diposition...I think the 30 shares are never held for a second and go immediately into cash to cover taxes.