What Is the Difference Between an Incentive Compared to a Non-Qualified Stock Option?
Your company may offer stock options as an additional form of compensation to its employees. The company may grant incentive stock options or nonqualified stock options. The main difference between these two types of options is their taxation. Incentive stock options also have two restriction periods on selling the option shares that do not apply to nonqualified options.
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Stock Options
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A stock option gives you the right to purchase a specific number of your company's shares at a guaranteed price. Your company must sell you its shares at the option price, regardless of high the stock is trading in the market. Companies issue stock options as a performance incentive to their employees. Your options become more valuable as the company's share price rises. This gives you an additional incentive to improve your company's performance.
Granting
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Your company grants you a stock option when it gives you the option contract. You are not taxed when nonqualified or incentive options are granted, but granting is restricted. A company can grant a maximum of $100,000 of incentive stock options to one employee per year. The employee must not sell his stock option shares for two years after the grant date. If he sells the shares early, the incentive options are taxed like nonqualified options.
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Exercise
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When you exercise your stock options, you buy the shares from your company at the option price. The IRS does not tax the exercise of incentive options, but does tax the exercise of nonqualified options. The difference between the current market price of your company's stock and the option price of a nonqualified option is taxed as income. While the incentive options are not taxed, the employee must not sell the shares for one year after the exercise date. If he sells the shares early, the options are reclassified as nonqualified and the employee owes income tax.
Selling
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Once you exercise your stock options, you own shares of your company's stock. You can sell the shares in the stock market whenever you want. The gain on the stock sale is taxed as a capital gain. When you sell an incentive option share, your total gain is the difference between the option price and the market price. When you sell a nonqualified option share, your gain is the difference between the market price and the exercise price. Your taxable gain is lower from the nonqualified option because you already paid income tax on the exercise date.
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References
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