Even your options have options. By providing equity in the company, stock options can be an effective means of attracting, retaining, and motivating employees and executives. The difference between the FMV of the stock at the exercise date and the exercise price is the option's bargain element.
Unexercised options expire after a period of time, as prescribed in the stock option plan.
At the time of exercising NQSOs, the bargain element is considered ordinary income to the recipient of the options. The FMV at the date of exercise is the recipient's basis in the stock. When the stock is sold, the difference between the sale proceeds and the exercise price is a capital gain. Like stock acquired through NQSOs, the capital gain holding period is measured from the date of exercise. The bargain element in ISOs is an addition to alternative minimum taxable income in the year the option is exercised.