How and when you exercise options can have big tax consequences. Stock options have become an important part of employee compensation packages. Employers view options as an effective means of attracting, retaining, and motivating employees, and employees enjoy the opportunity to participate in the appreciation of their employers' stock price. To maximize the benefits of options, employers and employees need to understand how different types of options are taxed and the methods for funding the exercise. 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.
The tax treatment differs substantially for each type. The FMV 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. When NQSOs are exercised, the issuing company must withhold social security taxes, federal income taxes, and possibly state taxes on the bargain element. 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.