Stock options are a popular way to reward senior managers and other key employees and align their interests with those of the company and other shareholders. Stock options give employees the right to buy a certain number of shares in the company at a fixed price, known as the grant price. That is usually the market price at the time the options are granted. If the share price rises, employees who have been granted stock will be able to exercise (purchase) the stock at the lower grant price and then sell it at the higher current market price.
Incentive stock options. These qualify for special favorable tax treatment by the IRS. The value of these options is not taxed to the employee nor deducted by the employer.
Non-qualified stock options. Because there are no statutory limits on the amount of this type of option that can be offered, non-qualified stock options are typically used to reward key employees. Also, they can be given to anyone who provides services to the company, not just employees. This could include independent contractors, advisors, and people who serve on a company’s board of directors.
Where these stock options are exercised, the person who exercises them becomes responsible for ordinary income tax on the difference between the exercise price and the market price of the shares. Any price appreciation after that would be taxed as a capital gain. The company receives a tax deduction when the employee exercises the stock options. Non-qualified stock options exercised by employees are subject to FCIA and FUTA taxes and income tax withholding just like regular pay.