There are two types of options commonly used as employee compensation: incentive stock options (ISOs) and nonqualified stock Options (NSOs). Incentive stock options (ISOs) may offer greater income tax benefits. The employee does not recognize income on the grant of ISOs and he / she does not recognize income on the exercise of ISOs. But the bargain element in an ISO is an addition to alternative minimum taxable income in the year the option is exercised.
When the stock is sold, the difference between the sale price and the exercise price is a capital gain, provided certain holding period requirements are met. Stock acquired under an ISO must be held for at least one year after the exercise date, or two years after the grant date. If ISO stock is sold before the end of the minimum holding period, the recipient must pay ordinary income tax rates which apply to disqualifying distributions. Like stock acquired through NSOs, the capital gain holding period is measured from the date of exercise. Nonqualified stock options (NSOs) are the most popular type of options offered today. The recipient employee does not pay income tax when the NSOs are granted (except in rare cases).
When the options are exercised, the bargain element is taxed as ordinary income to the employee (this is true even if the employee has given away the NSOs, for example, to a trust for his / her children). The fair market value at the date of exercise is the recipient's basis in the stock. If the stock price goes up after the options are exercised and the stock is later sold, this increase is a capital gain. The holding period for a capital gain is measured from the date of exercise. And when NSOs are exercised, the issuing company must withhold social security taxes, federal income taxes, and possibly state taxes on the bargain element. The company records an increase in salary expense for tax purposes (a deductible expense) equal to the bargain element.