Employee Stock Options         

For many years now, we have all been reading about the two most prized words in Silicon Valley:  stock options.  When a labor market gets as tight as it was in the internet industry during the good years, many companies will begin offering stock options to attract and retain top employees.

Using stock options, an employee has the right to purchase stock in the company at a specific (called "exercise") price at a specific time in the future.  As we have all read, many millionaires have been made over the years as employees watched their company's stock value (determined either by the market or a professional valuation) rise above the exercise price.

Companies offer two basic types of stock option plans: nonqualified plans and incentive stock option (ISO) plans.


Companies offer two basic types of stock option plans: nonqualified plans and incentive stock option (ISO) plans. Nonqualified plans and ISOs differ as to their qualification for special tax treatment, for both the employees who get them and the companies that grant them.

Nonqualified Options

An employee who receives nonqualified options will owe no taxes on his or her options until they are exercised. When an employee exercises the option, the company gets a tax deduction for the difference between the value at issuance and the exercise price.

An example of a nonqualified option would be when the company gives an employee 1,000 options with an exercise price of $10 when the company's stock is actually valued at $20 per share.  When the employee exercises the options, he or she will owe ordinary income tax on the difference between the original market price ($20) and the exercise price ($10).  In this instance, the amount taxable to the employee and deductible to the company would be $10,000 calculated as follows:

1,000 options at market value of $20

1,000 options at exercise price of $10

Total ordinary gain                                    




Once the employee owns the stock, his or her basis will be the market value at the time the options were exercised and any future gains or losses on a subsequent sale will be taxed as capital gains or losses.

Incentive Stock Options

ISOs, unlike nonqualified options, do not generate ordinary income to the employee.  Also, the employee will not owe taxes when the options are exercised.  Once the employee sells the stock, the stock appreciation is taxed at capital gain rates so long as the sale doesn't take place within two years after receiving the options or within one year after exercising them.  

The company gets no corporate deduction with the issuance or exercise of incentive stock options, but they are obviously more advantageous to the employee.  However, the gain on an ISO can subject the employee to the alternative minimum tax (AMT) in some circumstances where the employee is highly compensated.  If you have ISOs that you are considering exercising, you may want to call our office first to ensure that you are not placing yourself in an AMT situation.

Stock options are extremely popular, but they are not the only method of sharing equity with your employees.  To discuss all of your alternatives, we encourage you to contact us at your earliest convenience.