Many successful companies know the importance of rewarding and retaining key employees. One tool your employer may use is to offer stock options.
Stock options give you the opportunity to profit directly from your contribution to the success of your company. This is often reflected in the increased price and market value of the company’s stock.
Two common types granted to employees are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).
How ISOs work
- ISOs are mainly awarded to top executives or other key employees the employer wants to attract, incentivize, and/or retain. For these employees, it can represent a large portion of your overall compensation.
- ISOs granted by your employer give you the right to purchase shares of the company’s stock at a set time and predetermined purchase price. Depending on the structure of the plan, if you exercise the options, satisfy certain requirements, then you can receive favorable capital gains treatment.
- The term to exercise an option may be no more than ten years from the adoption of the stock option plan or approval by shareholders, whichever is earlier. Additionally, options must be exercised while you’re employed or within three months following employment termination.
How NSOs work
With NSOs, your employer gives you the right to purchase a specific number of shares at a predetermined price (both requirements set by the company). These options may be offered to a wider base of employees—including independent contractors—to create an atmosphere of shared rewards.
In fact, depending on the value of your option at the time you exercise the stock, this could add a substantial amount of income to your tax return.
From a tax standpoint—assuming no election was made under the Section 83(b) tax laws—the excess of the fair market value of the stock over the option exercise price will be considered ordinary income.
Any appreciation or depreciation of the stock after your exercising the option will be capital gain or loss.
Speak with a professional
Understanding how options work and deciding when and how to exercise them can be challenging, especially when it comes to the legal and tax requirements.