Employer-Granted Stock Options
Employers grant stock options as a method of rewarding and motivating valued personnel. The two types -- nonqualified (also called nonstatutory) and incentive or qualified stock options -- are subject to different rules and taxation. Employer-granted stock options used to be perks reserved for executives. Today, many companies offer them to a broad range of employees.
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Description
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Employer-granted stock options are contracts that confer the right to buy a stated number of shares of the company's stock at a specified price, called the strike or exercise price. The options are good until an expiration date, usually several years in the future. Employers may stipulate that the employee wait for a period of time before exercising the options. If the stock increases in price, the employee makes a profit by exercising the options and then selling the shares. For example, if the strike price is $25 per share and the market price has risen to $45 per share, the employee can make a $20 per share profit.
Nonqualified Stock Options
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A company may grant nonqualified stock options to employees and to some non-employees, such as members of its board of directors. If the options are eventually exercised, the employee usually sells the stock immediately and collects the profits, which are taxable as ordinary income in the year the options are exercised. Nonqualified stock options do not qualify for reduced long-term capital gains tax rates, regardless of how long the employee waits to exercise the options. This is because the employee doesn't actually own the stock prior to exercise, only the right to buy it at the strike price.
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Incentive Options Grant Rules
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Unlike nonqualified stock options, the profits from incentive stock options may qualify for lower long-term capital gains tax rates. Special IRS rules must be followed for the employee to reap this tax advantage. The strike price must be equal to or greater than the stock's market price on the day the options are granted. In addition, a company can grant a maximum of $100,000 of incentive stock options that are exercisable in any one year.
Incentive Holding Rules
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Under IRS rules, an employee must wait more than one year before exercising incentive stock options. Once the options are exercised, the employee must hold the shares for more than one additional year before selling them. Profits are not taxable in the year of exercise, but in the year the shares are sold. If the employee follows these rules the profit is considered a long-term capital gain and taxed at lower rates. If the employee fails to wait the required time to exercise and then to sell the stock, the profits are taxable as ordinary income in the year the options are exercised.
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