Employee stock options are a benefit many companies use as an incentive and to align the interests of the company and its employees. There are two types of employee stock options: non-qualified (or non-statutory) and incentive stock options. Non-qualified stock options are the most common and you should understand the tax impact they have and how the tax implications differ from those pertaining to incentive stock options.
When a company awards non-qualified stock options, you get the right to purchase a specific number of shares of the company stock at a guaranteed exercise price. The options are good for a limited period of time (usually several years). Strictly speaking, you do not sell non-qualified stock options. You use the options to buy the stock at the exercise price if the company stock goes up in price, and then sell the shares at the higher market price.
When you exercise non-qualified stock options, the difference between the exercise price and the market price on the day of exercise is profit and is referred to as the compensation element. This profit is considered to be compensation by the Internal Revenue Service and is reported on your W-2 form at the end of the year. The compensation element is taxed as ordinary income along with your other wages. These taxes are due in the year the exercise takes place.
Most of the time people almost immediately sell shares they purchase with non-qualified stock options. However, you might choose to hold the stock for a time during which the price may change. If you follow this course, the market price on the day of exercise is considered your cost basis (the amount you have invested in the stock). When you do sell the shares, you subtract the cost basis and any transaction expenses from the total sale proceeds. The difference is considered a capital gain (or loss if the stock fell in price since you exercised the options). This is reported as a long-term capital gain or loss if you held the shares for more than a year from the exercise date. If you sold the stock in a year or less, you have a short-term capital gain or loss.
Incentive Stock Options
Incentive stock options, or ISOs, are similar to non-qualified options except for the tax impact. You are supposed to wait at least one year after being awarded ISOs before exercising the options. Then you must hold the shares for at least one additional year. If you follow thee holding rules, all of your profit is considered a long-term capital gain and taxed at a maximum rate of 15 percent. This means the difference between the exercise price and the market price on the day of exercise is taxed as a long-term capital gain, not as ordinary income.