One strategy companies have used in recent years is to reward employees with options to purchase a certain amount of the company's stock for a fixed price after a defined period of time. The employee is not required to exercise the option. Usually (and hopefully), by the time the employee's options vest (become eligible for exercising), the market price of the stock has gone up, and they get to buy the stock for a lower price than what it's going for in the current market. A stock option is a contract which allows the holder to purchase stock at a fixed price, typically known as the "exercise price". There are two classifications of employee stock options: (1) statutory or qualified options (i.e. the tax treatment of the options is governed by specific Internal Revenue Code Sections) and (2) Nonqualified stock options (i.e., stock options that do not meet specific requirements in the Internal Revenue Code for special tax treatment). There are two types of qualified stock options: Incentive stock options (ISO) and options written under the employee stock purchase plans (ESPP) - Tax Implications of Exercising Qualified Stock Options - Generally, an ISO allows the grantee to postpone taxation of option gains until option shares are disposed of, at which time the gain will be taxed at favorable capital gains rates. - Employee Stock Purchase Plans (ESPP) - Employee stock purchase plans are written, shareholder-approved plans under which employees are granted options to purchase shares of their employer's stock or the stock of a parent or subsidiary corporation for not less than 85% of their fair market value. If the option price is less than the fair market value of the stock at the time the option is granted, the employee recognizes ordinary income in the amount of the lesser of (1) difference between the fair market value of the shares when sold (or the fair market value of the shares at the employee's death while owning the shares) and the option price for the shares or (2) the difference between the option price and the fair market value of the shares when the option was granted. The balance of the gain is treated as capital gain. - Tax Implications of Exercising Nonqualified Stock Options - Typically, income is recognized at the time an employee exercises nonqualified options. The amount included as taxable compensation is the fair market value (FMV) of the stock on the exercise date, minus the amount paid (exercise price). Compensation is reported to an employee in box 1 of form W-2 and in box 12 with a code "v." Income and employment taxes are withheld on this income. For our purposes, let's assume that you receive options for stock that is actively traded on an established market such as NASDAQ, but that the options themselves aren't traded. With this type of option you must recognize taxable income equal to what's called the compensation element when you exercise the stock options and purchase the stock. - Compensation Element Defined - Your compensation element is basically the amount of discount that you get when you buy the stock using your options. It's calculated as (market value - stock grant price) x number of shares you buy The market value of the stock is the stock value on the date you exercise the options (i.e., the date you buy the stock under your option agreement). The stock grant price is the amount that you can buy the stock for per your option agreement. Your employer is required to report the compensation element on your Form W-2 for the year you exercise the options. - Restricted Stock Awards - Unlike options, which may or may not be exercised, restricted stock awards put shares into the grantee's name up front, subject to forfeiture during the period of restriction. Any price paid by the grantee is typically well below market (if the shares are newly issued, state corporation law may require a payment equal to par value), and when the restrictions lapse the grantee will have gained something even if the market price has fallen. The nature and duration of the conditions attached to restricted stock can be specifically tailored for each grantee. In many cases, the condition is simply continued employment for a specified period. - Tax Treatment of Restricted Stock Awards - The excess of the restricted stock's market value at the date when the risk of forfeiture or restrictions on transferability lapse over any price paid for the stock is treated as compensation income to the grantee, and any subsequent change in the value of the shares will be recognized for tax purposes as capital gain or loss upon disposition of the shares. - Section 83(b) Elections - In the alternative, the grantee may elect under I.R.C. § 83(b) to recognize compensation income at the time of the initial transfer of the shares, based on the value of the shares at that time (rather than at the time of vesting). No income will be recognized upon lapse of the risk of forfeiture or restrictions on transferability and subsequent appreciation or depreciation will be recognized as capital gain or loss. The grantee will not be entitled to any loss deduction if the shares with respect to which a § 83(b) election was made are later forfeited. - Conclusion - Stock options can be a great way for employers to increase the compensation package of their employees and a great way for employees to invest in their employer. Just remember that there are numerous tax effects that vary based on the type of option. Be sure to check with your Tax Coach whenever you receive the opportunity to acquire an option in your company.