Many large, publicly traded companies started using employee stock options as a benefit a few years ago. Employee stock options give the employee the ability the option to purchase the company stock at some point in the future at a certain pre-fixed price, called the strike price. The vesting schedule that is provided to employees when the options are awarded specifies when the purchase can take place. Purchasing the stock is called exercising the option. Options are issued in groups called grants. Parts of each grant vests over a particular schedule, the vesting schedule.

There are two types of employee stock options, incentive and non qualified stock options. You can differentiate between the two by the way you are taxed on them.

Incentive Stock Options

Incentive stock options (ISOs) qualify for special tax treatment. They are not taxable when issued to you or, in most cases, when you exercise them to buy your company stock. If you keep the stock for at least one year from your exercise date before selling it, and two years from the date your employer granted the ISO to you, you will only pay capital gains tax on your profit. In most cases, the capital gains tax rate is lower than the tax on your income. Remember, this special treatment only really matters if the stock increases in value after you purchase it.

ISOs are tricky because their special tax exclusion at exercise can generate something called an alternative minimum tax, or AMT. This alternate income tax calculation disallows many common tax deductions and benefits that you claim on your regular tax return and assigns a minimum tax amount that the taxpayer must pay. This AMT could be due when you exercise your ISO options when regular income tax normally wouldn’t be, making ISOs less appealing if the stock then loses value while you’re waiting for the one-year anniversary to sell.

Expert advice is very important when working with stock options. Be careful not to let the tax tail wag the option dog. While waiting a mandatory twelve months to get a lower tax rate on your stock sale, you might lose more in lost stock value than you would have saved in taxes. Your CPA or financial advisor will help you decide whether exercising and selling ISO stock immediately is a better idea than holding the stock and taking the risk that it loses value.

Nonqualified Stock Options

Nonqualified stock options are not eligible for the special tax treatment of incentive stock options hence their name. When you exercise non-quals, as they are called, the difference between the strike price and the value of the stock is immediately taxable as income. Check your pay stub and your W-2 form and you’ll see this value represented as income.

Companies anxious to avoid recent controversies surrounding stock option accounting and backdating have reduced or stopped issuing new stock option grants in favor of issuing restricted stock. Employees own the stock right away, but are limited by a vesting schedule that dictates when they can sell.

Strategies and Mistakes

Deciding whether to hold your company stock after exercising a stock option can be a difficult choice. Many people make the mistake of letting their fear of taxes drive their decision. The fact is that the employee stock option is a benefit that encourages you to own company stock. The argument goes that owning company stock gives employees some skin in the game and makes them more interested and invested in the overall performance of their company. It’s also cheaper for the company to give you options than to give you a straight cash bonus. Think about whether you are better off with the cash than with the stock. If you have few other assets to diversify against your company stock, it may be better for you to sell the stock and invest the gains in a mutual fund or other investment less concentrated in the fortunes of your employer.