Tax Treatment for Qualified Stock Options
If your employer grants you qualified stock options (also called incentive stock options) it can be a really good deal. Your profits can be treated as long-term capital gains provided you follow the rules set forth by the IRS. As a result, you'll pay a maximum of 15 percent in income taxes on those profits instead of the higher rates applied to ordinary income.
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Qualifying Rules
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Two rules must be followed when the options are granted for the profits from an employee stock option to qualify for tax treatment as capital gains. First, the person receiving the options must be an employee of the company. Second, the exercise price must be equal to or greater than the stock's market price on the date the options are granted. The exercise price is the price per share the employee must pay the company to purchase the number of shares stated in the option contract.
Exercise
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Once a qualified stock option is granted, the employee must wait at least one year before exercising the option to purchasing the shares. However, no taxes on any profits are due until the stock is sold. This is different from non-qualified stock options, for which profits are taxable in the year the option is exercised.
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Holding Period
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The final requirement that must be met for profits from qualified stock options to be considered long-term capital gains is for the employee to hold the shares for at least one year after the date options are exercised. Provided this condition is met, all profits are considered long-term capital gains by the IRS. For example, suppose a qualified stock option has an exercise price of $30 per share, is exercised after one year with the market price at $40 per share, and sold a year later at $50 per share. The entire difference between the exercise price of $30 per share and the sale price ($20 per share) qualifies for capital gains tax rates.
Disqualifying Disposition
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The IRS does not impose any penalties in the event of a disqualifying disposition of qualified stock options. Disqualifying disposition is a fancy way of saying you didn't wait long enough to exercise the options or to sell the shares. However, if this happens, the options will be treated as non-qualified stock options. Any profits you make will not be considered long-term capital gains and will be taxed as ordinary income at rates up to 35 percent (as of 2011).
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