The Taxation of Incentive Stock Options
Companies grant stock options to employees as a reward and as a motivation. An employee stock option confers the right to buy shares of company stock at a predetermined "strike" price for a limited time. If you are awarded stock options by your employer, they may be either incentive stock options or non-qualified stock options. Profits from incentive stock options may qualify for lower capital gains tax rates, whereas non-qualified options are taxed as ordinary income.
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Grant Terms
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Incentive stock options must have a strike price that is equal to or greater than the market price of the stock on the date the options are awarded. Companies may award incentive stock options to employees only. For instance, a member of the board of directors may not be granted incentive stock options unless she is also an employee. Provided you follow IRS procedures for incentive stock options, all profits you make will qualify for long-term capital gains tax rates (15 percent or less as of 2010) instead of being taxed at the higher rates applied to other income.
Waiting Period
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You must wait at least one year from the date incentive stock options are awarded before exercising them (using them to buy the stock). Normally you do not pay taxes on profits until the tax year in which the stock is sold. However, Fairmark says that if you are subject to the alternative minimum tax, you may have to pay tax on profits in the year of exercise and recover the money in the form of credits in future years.
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Holding Period
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Once you exercise an incentive stock option, you must hold the stock for a minimum of one additional year before selling the shares. When the one year holding period has elapsed, you can sell the stock and all profit you make will be considered long-term capital gains. This includes profit due to any stock price increase between the time the options were granted and the date of exercise.
Example
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Suppose you are awarded incentive stock options for 1,000 shares with a strike price of $25 per share. One year later the stock is selling for $35 per share. For a non-qualified stock option, your profit of $10 per share would be taxable in the year of exercise as ordinary income. However, since these are incentive stock options, you hold onto the shares for another year. No taxes have to be paid during the holding period. At the end of the year the stock is at $40 per share and you sell the shares. You will have to pay taxes on the total profit of $15 per share in the tax year the sale took place. However, the profits are considered long-term capital gains, so you will be taxed at 15 percent or less.
Considerations
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The IRS does not levy a tax penalty if you exercise incentive stock options or sell the shares prematurely. However, the options will be considered non-qualified stock options and taxed accordingly. You lose the tax advantage. Finally, if you leave the employ of the company that awarded you the incentive stock options, you must exercise them within 90 days of leaving or they will revert to non-qualified stock options.
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