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Employee Stock Options -- Tax Considerations

You should consider the tax implications of stock options from your employer.

Companies will sometimes reward certain employees with stock options. The thinking is that, along with other parts of the total compensation package, stock options will help retain key employees and incentivize them to work harder to help the company meet its goals.

Essentially, a stock option gives an employee the right to buy shares of company stock at a predetermined price at a point in the future. That future date is known as the "vesting" date. The employee cannot exercise the options until the vesting date is reached. The cost to buy shares, or exercise the options, is known as the "strike" price and is typically based on the fair market value of the stock at the time of the grant. If the company prospers and its stock price increases, the employee can benefit because his or her employee stock options will be more valuable.

Two Types of Options

Employee stock options can be either incentive stock options (ISOs) or non-qualified stock options (NSOs). An ISO gives employees the right to buy shares in their company at a discounted price. In general, ISOs are awarded only to senior management and key people within a company. NSOs allow employees to buy a company's shares at a preset price. Employees can lose the options if they leave the company before the options are vested. NSOs may also contain "clawback" provisions that permit the company to reclaim the options for a variety of reasons.

ISO Tax Treatment

If you receive ISOs, you will not be taxed at the time the options are granted. There is no regular income tax due when ISOs are exercised, but the alternative minimum tax may apply to the "bargain" element, which is the difference between what you pay for the ISO stock and its value. When you sell ISO stock, your capital gain (the difference between the amount you paid for the stock and the amount you realize on the sale) is taxable to you. The favorable long-term capital gain rates will generally apply if the sale takes place more than two years from the option grant date and more than one year from the date of exercise. If you sell the stock earlier, part of your gain will be taxed at regular tax rates.

NSO Tax Treatment

Employees who receive NSOs are generally not considered to have received any income nor are they liable for income tax until they exercise their options. There is an exception: If the options have a "readily ascertainable" value when they are granted, the income is taxed at ordinary rates at that time. When you exercise an NSO that wasn't taxed at grant, you typically recognize ordinary income equal to the difference between the fair market value of the stock on the date of exercise and the exercise price. When you later sell the stock, you will be taxed on your capital gain.

Knowing how you'll be taxed is vital when you are making decisions about employee stock options. It may make sense to seek out the input of a financial and tax professional before making any moves in this regard.