Employee stock options give the employee the right, but not the obligation, to purchase stock in the corporation at a fixed price on a specified date or during a specified interval of time. When the options are granted, there are usually restrictions as to when they can be exercised or when the acquired stock can be sold or there may be a risk of forfeiture of the acquired stock until the employee satisfies certain conditions, such as working for the employer a certain number of years.

When all restrictions or risk of forfeiture are removed, then the options or the acquired stock are said to be vested , meaning that the employee has an irrevocable right to the property.

How the options are taxed depends on what type of options they are, whether there was a discount when the options were granted, and the time intervals between the options grant date, exercise date, and stock sale date.

A disadvantage of compensating employees with stock options rather than with restricted stock, however, is that options may lose significant value before they become vested. Restricted stock , on the other hand, will always have some value unless the business becomes financially insolvent.

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Statutory options receive preferential tax treatment. If certain holding rules are followed, employees do not incur regular income tax liability either when the option is granted or when it is exercised, and any gains are treated as capital gains rather than as ordinary income. However, if vested options are exercised, then the option spread , which is equal to the exercised stock price minus the option price, must be reported as a positive adjustment to the alternative minimum tax AMT if held beyond the end of the tax year.

AMT liability does not have to be reported if the stock is sold before the end of the tax year, since it will then have to be reported as taxable income under the regular tax system. ISOs are generally taxed when the purchased stock is sold — ISOs are not taxed when they are granted or when they are exercised.

For ISOs to qualify under the tax rules as statutory stock options, they must be exercisable within 10 years of the grant date and the option price must at least equal the fair market value of the stock when granted.

If the employee leaves the corporation, then the ISO must be exercised within 3 months after employment termination; otherwise, the income is taxed as nonstatutory stock options.

The option holder should receive Copy B of Form , Exercise of an Incentive Stock Option under Section b from the company when the ISO is exercised, showing the following information:.

Copy A of Form goes to the IRS. The information contained in this form should be used to calculate gain when the shares are sold or to calculate the AMT adjustment, if applicable. A long-term capital gain or loss can be claimed on the stock only if the stock was held for at least 2 years after the ISO was granted and at least 1 year after the exercise of the option.

These holding period rules are considered satisfied if an earlier sale was motivated to comply with conflict-of-interest requirements.

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If the holding period test was not satisfied, then the gain on the stock sale is treated as ordinary wage income that is equal to the option spread:. Although you held the stock for more than 1 year, you did not hold it for at least 2 years from the option grant date.

Employee Stock Purchase Plans ESPPs are written shareholder approved plans where employees are granted options to purchase shares of the employer's stock or of its parent or subsidiary corporation. To be treated under statutory option rules:. Stock purchases under an ESPP are subject to the same holding period rules as for ISOs.

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Tax does not have to be paid until the stock is sold and the gain, minus any amount treated as wages, is treated as capital gain. If the stock is sold at a loss, then it is a capital loss.

If holding periods are not satisfied, then the employee recognizes ordinary income as the lesser of. If the employee exercised an option granted under an ESPP, then he should receive Form , Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section c after the end of the tax year. In most cases, an option will not have a readily ascertainable fair market value unless it is traded on a public exchange, and since employee options are never traded on public exchanges, they will almost never have a readily ascertainable fair market value.

Vested options without an ascertainable FMV are taxed as ordinary income in the year that the option is exercised:. If the stock is not vested, then the income is deferred until the year that the stock vests.

In the vesting year, gains are taxed as ordinary wage income that is equal to the value of the stock as of the vesting date minus the amount paid, even if the taxpayer holds onto the stock. Ordinary wage income is subject to both income and employment taxes. Nonstatutory stock options may be granted in addition to incentive stock options. Unlike ISOs, there is no restriction on the number of nonstatutory stock options that can be granted since they do not receive favorable tax treatment.

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Amount reported as wages: