Although companies have all kinds of ways in which they can structure the stock options they give employees, the tax code essentially recognizes just two types: incentive stock options and non-statutory stock options. Incentive options are those that qualify for special tax treatment under criteria spelled out in the Internal Revenue Code. Any options that don't meet these standards -- that aren't defined by statute, in other words -- are "non-statutory" options.
Where Options Fit In
Stock options give you the right to buy shares of company stock at a pre-set price, called the strike price or exercise price, at some point in time. Companies give employees options as compensation, as incentives to remain with the company or to help improve its performance, and as rewards. Note, however, that "incentive stock options" is just a legal term to describe options that meet technical criteria in the tax code. Options given as compensation, for example, may qualify as incentive options, while options given as an incentive may be non-statutory. If you've received options, your employer can tell you whether they're incentive or non-statutory. Incentive options are also called statutory options; non-statutory options are also known as "non-qualified" options, since they don't qualify for the special tax treatment.
Tax Implications When Receiving
Employees who receive non-statutory stock options usually won't incur any tax liability at the time they get the options. That's because it's standard practice to set the strike price of the option equal to the share price of the stock at the time the option is issued. If your company gave you an option to buy stock at $10 a share, for example, and the stock was trading at $10 a share when you got the option, then you haven't received anything of value that can be taxed. However, if the company were to give you an option with a strike price of $8, the $2 difference per share may be taxable.
Taxes Due After Exercise
When you exercise a non-statutory option, the difference between the strike price and the share price is taxed as ordinary income, like wages from a job. Say you had an option for stock at $10 a share, and you exercised it while the stock was $15 a share. You'll have to report and pay taxes on that $5-per-share difference. With incentive options, you don't incur regular income tax when you exercise the option.
Selling the Stock Later On
When you sell stock that you purchased by exercising a non-statutory option, capital gains taxes apply. Say you exercise a $10 option on a share of stock that's selling for $15. You later sell the stock for $18. The $3 difference between the stock's value when you bought it and the time you sold it is a capital gain. If you own the stock for less than a year, your capital gain is a short-term gain, and it will usually be taxed at the highest rate that applies to your ordinary income. If you own the stock for more than a year, your gain is a long-term gain, which is taxed at a lower rate. The maximum rate on short-term gains was 43.4 percent as of the time of publication; the maximum rate on most long-term gains was 23.8 percent.