As a form of compensation, some companies issue stock options to employees.
Incentive Stock Options (ISO), or Nonqualified Stock Options (NSO) is the
general form which these stock options take. For preferential tax treatment,
ISO's must satisfy the conditions of the Internal Revenue Code, so they are more
restrictive than NSOs. For example, ISOs cannot be granted at a discount to the
current stock price as Nonqualified Stock Options can. However, Incentive Stock
Options can only be granted to employees On the grant date, and the exercise
price cannot be lower than the fair market value of the stock. Except through a
will, these options cannot be transferred to another person.
When the options are granted, income tax is not charged when they are
exercised, the employee pays no tax. Income tax for the employee is deferred
until after the employee sells the stock obtained through the exercise of the
options, with these above mentioned options. As long as the stock is held at
least one year after exercise of the options and at least two years after they
are granted, Capital gains are taxed as long term gains. Otherwise, the
subsequent gain after the exercise is taxed as short term capital gains and the
gain at exercise is taxed as ordinary income. The difference between the option
exercise price and the stock value at the time of option exercised, is what
measures the gain at exercise. Favorable tax treatment is lost if the Incentive
Stock Option is exercised more than three months after the employee has left
employment at the company which granted the options.
Although there is no federal income tax at the time of exercise, the paper
gain at exercise is subject to the alternative minimum tax (AMT) when an ISO is
exercised and held, but this is merely a prepayment of tax, which will be
credited back by the IRS at final disposition of the sale of the stock obtained
when the option is exercised.
