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To explain stock options it is important to understand that there are many different things referred to as “stock options.” One kind of stock option is the marketable securities traded on options exchanges like the one in Chicago. These stock options are bought and sold by investors and tied to the company’s stock price, and have nothing to do with employee stock options.
The other kind of stock options are those granted to employees or executives of a company as a form of compensation. There are two kinds of these stock options, Incentive Stock Options, sometimes known as ISO, and non-qualified stock options which are typically only given to executives and company founders or investors. When most people are talking about the stock options that come from an employer, they are talking about incentive stock options.
Incentive stock options work by allowing the employee to purchase company stock at a specific price, known as the strike price. This price is typically above the current market price when the options are granted. The idea is that if the company does well, thanks in part to the employee’s contributions, the stock price per share will rise, and the employee will benefit from that increase in share price. These employee stock options also generally vest over a specific period of time, typically a number of years. This vesting schedule acts as an incentive for the employee to stay with the company since any remaining ISO not exercised before the employee leaves are often forfeited.
Employees profit from exercising their stock options once the stock price has risen above the option’s strike price. The amount of profit is equal to the difference between the market price at the time of exercise minus the strike price, multiplied by the number of shares, or number of options, minus any expenses.
Theoretically, to exercise employee stock options, the employee buys the company stock at the strike price, then turns around and sells the stock at the current market price. This could necessitate a sizable amount of cash up front in order to purchase the original shares. Fortunately, many companies offer what is known as a “cashless exercise” in which the company, through a financial intermediary, both purchases the shares of stock and then sells those same shares without any funds from the employee. The employee then receives the net proceeds of the transaction minus any fees or expenses.
Incentive stock option taxation is usually calculated as a capital gain equivalent to the net proceeds of the transaction, so long as certain holding periods have been met. Typically, the employee must either hold the purchased stock for at least one year, or the employee needs to have had the stock options for 2 years. Otherwise, the profits from the transaction may be partially taxed as ordinary income.