An employee stock option gives you the right to purchase a specific number of shares of your company’s stock, at a specific price, within a specific time period. The grant price is typically the market value of the stock at the time your company granted you the options. For tax purposes, employee stock options are classified as either Incentive Stock Options (ISOs) or Non-qualified Stock Options (Non-Quals). The primary difference between the two is in their tax treatment.
Non-Qualified Stock Options (Non-Quals): A Non-qualified stock option does not qualify you for preferential tax treatment. You will pay ordinary income tax on the difference between the grant price and the Fair Market Value of the stock at the time you exercise the option.
Incentive Stock Options (ISOs): Incentive Stock Options are qualified under IRS Code Sec. 422 to receive special tax treatment. Generally, no income tax is due at grant or exercise. Rather, the tax on the difference between the grant price and the Fair Market Value (FMV) of the stock on the exercise date is deferred until you sell the stock. At that point, your tax rate varies based on how long you owned the stock. If you sell the stock after one year from the exercise and two years from the grant date, you will receive long-term capital gains tax treatment. If you sell stock within one year of exercise or two years of grant, your gain will be treated as ordinary income. You may also be subject to the Alternative Minimum Tax.
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