Companies frequently grant stock options to valued employees as an incentive and reward. At one time, stock option awards were almost exclusively reserved for corporate executives. Today, it is routine for midlevel managers to be granted stock options as well. As a result, executive stock options are now commonly referred to as employee stock options.
An executive stock option is a contract that grants the right to buy a specified number of shares of the company's stock at a guaranteed "strike price" for a period of time, usually several years. The executive is under no obligation to exercise, or use, the options, but if she decides to do so, the company must honor the contract. If the company's stock goes up in price, the executive can exercise the options to buy stock at the strike price and then sell the shares at the market price, keeping the difference as profit.
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Nonqualified Stock Options
The most common form of employee or executive stock options is the nonqualified stock option. The name refers to the fact that profits from the options are not qualified for long-term capital gains tax rates. Typically, an executive will sell the shares immediately upon exercise the option, often in the form of a cashless exercise. The executive takes the options to his broker, who loans the executive the funds to exercise the option. The broker then sells the shares, recovering the borrowed funds and depositing the difference in the executive's account. The executive thereby avoids the inconvenience of raising the cash required to pay the strike price.
Incentive stock options, or ISOs, are a special form of executive or employee stock option that can qualify for capital gains tax rates, provided that certain rules are followed. The executive must hold the options for at least 1 year after they are granted before exercising them. Once the options are exercised, the shares must be held for at least 1 additional year. At that point the shares may be sold, and all profits are eligible for long-term capital gains tax rates. This includes profits resulting from price increases that occurred between the time the options were granted and the date of exercise.