Incentive Stock Options (ISOs)
An employee is not taxed on the receipt of these options. When the option is exercised, the difference between the option price and the fair market value of the shares (called the “spread”) is not subject to income tax. But when the option is exercised, the spread is an adjustment for alternative minimum tax purposes.
If the shares acquired pursuant to the option are sold more than one year after the option was exercised and more than two years after date of grant, the gain (the difference between the option price and the stock’s selling price) is long-term capital gain.
If both holding periods are not met, the difference between the option price and the fair market value at date of exercise is ordinary income. The remaining gain is long-term or short-term depending on holding period.
Long-term capital gains tax rates are much lower than short-term gains and ordinary income tax rates!
Nonqualified Stock Options
The tax treatment depends on whether the employee works for a publicly held or closely held corporation:
- If an option is actively traded or has a readily ascertainable value, then the employee recognizes ordinary income on the receipt of the option. There is no further taxation on the exercise of the option. When shares acquired pursuant to the option are sold, capital gain may result.
- If the option is not traded on an established market, then the grant of the option is not taxed to the employee. Instead, the employee becomes taxable when the option is exercised. The amount of compensation is the difference between the stock’s fair market value and the exercise price.
The income resulting from the exercise of nonqualified stock options is treated as taxable compensation equal to the excess of the fair market value of the stock received over the purchase price of the stock and is reported as such on Form W-2. Compensation reported on a W-2 is taxed as ordinary income.