Employers sometimes choose to pay part of their employees' compensation packages with stock options. The programs are intended to increase employees' interest in the performance of the company beyond their hourly pay. Depending on the employer's choice, the stock option program may distribute incentive stock options (ISOs) or non-qualifying stock options (NSOs).
Stock options allow their holders to purchase some amount of a certain stock at a specified price, called the stock price. The holder can wait until the market price is higher than the strike price, exercise the option, and immediately sell the shares at a profit. He also could exercise the option and keep the shares. At some point after issue -- usually after 10 years -- the options expire. This means that if the market price never rises above the strike price, the holder will never exercise the option.
One difference between ISOs and NSOs is that different people are eligible to receive them. A company with an ISO program can give options only to employees. An NSO program can give options to anyone the company designates. For example, independent contractors or outside consultants may receive stock options in exchange for their services. Employees can also receive NSOs. Both option types operate in the same way; however, the holders' decisions may be different because of the different ways in which they are taxed.
If an employee exercises an ISO and keeps the shares for at least one year after that and at least two years after the initial issue of the option, the gains from the eventual sale are taxed as capital gains. If the employee does not wait that period to sell the shares, they are treated as though they came from an NSO. When a holder exercises an NSO, the difference between the strike price and the market price is immediately taxable at the holder's income tax rate. The company that issued the option deducts the difference in prices.
Alternative Minimum Tax
It may seem ISOs are more favorable for employees, but they are often worse for employees with higher incomes. This is because the difference between the strike price and market price, though nontaxable under regular tax, is included in income for the purposes of calculating the alternative minimum tax. The alternative minimum tax rate is 26 percent up to $175,000 of taxable income and 28 percent of higher amounts.