Understanding Stock Options

Despite the controversy they have garnered lately, stock 
options are still fairly popular incentives for employees. 
Whether you work for a public or private company, you may reap
the benefits of these plans either today or in the future. We 
will focus on two types of stock options, non qualified stock 
options (NQSO) and incentive stock options (ISO) and how you 
could be taxed on these plans. 

First let's go over some terminology for stock options. 

* Grant date: The date you are given stock options. 
* Vesting Period: Dates you are eligible to exercise the stock
  options. * Exercise price: Amount you pay to exercise your 
  stock options. 
* Fair Market Value: current price of your stock. 
* Bargain element: The difference between the exercise price 
  and the fair market value of the stock. For example you 
  exercise your stock for $10 a share and the current price is
  $20. Your bargain element is $10. 
* Alternative minimum tax (AMT): This is an extra tax some of 
  you may have to pay above your regular income tax. The idea 
  behind it is to prevent people with really high incomes from
  paying little or no tax via special tax benefits or 
  deductions. 

Non Qualified Stock Options (NQSO) 

Non qualified stock options are options that don't receive 
favorable tax treatment or deferrals. Your company does get a 
tax deduction on these plans and NQSO's are taxable at 
exercise. 

To illustrate the tax situation, let's use the example from 
above with the stock currently trading at $30. You exercise at
$10. You will pay ordinary tax on the $20 gain ($30 market 
value minus $10 exercise). Your cost basis is now $30. What if
the stock hits $50 a year later? Then you will owe long term 
capital gains tax on the subsequent $20 gain ($50-$30). 

Incentive Stock Option (ISO) 

This is also known as qualified stock options and is a tax 
favored plan. No taxes are due when you exercise ISO's. 
Typically only $100,000 worth of ISO's granted in one calendar
year gets favorable tax treatment. Anything above that gets 
treated as non qualified stock options. 

You have to be aware of the alternative minimum tax (AMT) on 
the bargain element at exercise. Suppose you were granted 
options and exercise them at $10 per share and the stock is 
valued at $30. The discount or bargain element equals $20. No 
taxes are due at this time. However the $20 bargain element 
could put you in AMT territory creating a higher tax bill for 
you. 

Remember you must hold the stock for two years after the grant
date and one year after your exercise date to get favored long
term capital gains treatment. If you sell the stock earlier, 
you will pay ordinary income tax on the bargain element ($20 
gain above the exercise in this case), and any ensuing gains 
since the exercise. Let's say the stock goes to $50 one year 
after the exercise at $10.00 and 2 years after the stock has 
been granted to you. The subsequent $40.00 gain will receive 
long term capital gains treatment. 

There is a lot more to discuss, especially on when you should 
exercise these options. We will discuss them in the coming 
weeks. For now know that the main difference between NQSO's 
and ISO's relates to their taxation. NQSO's are subject to 
regular income tax at exercise whereas ISO's are not. If you 
are in a high income bracket, you must pay attention to AMT 
when it comes to ISO's as it may apply to you in the year of 
exercise. These are difficult financial planning issues so 
please go to an advisor familiar with the ins and outs of 
these plans.