In simplest terms, a stock option gives the holder the right to buy or sell a certain number of shares of a given stock, at a fixed price (strike price) until a specified date. When a stock option is exercised, the holder actually does buy or sell the specified number of stock shares. The IRS will be looking for its share of the proceeds from the exercise of your stock options.
Stock options are no longer only for the executives of a company. An increasing number of companies of all sizes are offering their employees stock options as bonuses or part of their compensation package. There are two basic types of employee stock options: non-qualified and qualified, or incentive stock options (ISOs). The non-qualified variety can be given to you at a lower price than the stock's current market value and can also be transferred to your children or favorite charity, if your employer allows it. Often, ISOs are distributed to upper-level management and non-qualified stock options go to other employees.
The proceeds from the exercise of ISOs are taxed, but at the capital gains tax rate of 15 percent versus the higher ordinary income rate. To qualify for capital gains treatment, you must own the shares over a year and sell them more than two years after the grant date. Proceeds from the exercise of non-qualified stock options are taxed according to when and how you choose to exercise your options. The compensation is reported by your employer on your Form W-2 as compensation, just like your salary. You may also be responsible for capital gains taxes if you sold the stock options less than a year after receiving them. If you exercise your option to purchase shares, but decide to hang onto them, your compensation amount (market price -- exercise price x number of shares) still gets reported on your Form W-2 as income.
There are three primary ways to exercise options to purchase company stock. A cash exercise entails you paying your employer the necessary cash to purchase shares at the grant price dictated in the contract and receiving stock certificates in return. When you already own company stock, your employer may allow you to do a stock swap. You own 2,000 shares of stock valued at $50 per share and you are granted an option to buy 3,000 additional shares at $25 each. Rather than paying $75,000 (3,000 x $25) to exercise your option to buy, you can trade 1,500 of the shares (1,500 x $50) you already own to acquire the additional 3,000 shares. Finally, you may be able to arrange a cashless exercise, in which the money to purchase stock is borrowed from a stockbroker, while simultaneously selling enough shares to cover all costs, taxes and broker commissions. The remaining proceeds can be paid to you in cash or stock.
A copy of the options contract should be available to you when your employer grants you non-qualified stock options or ISOs. The agreement outlines all rules and contingencies for exercising your options. Your employer is required to withhold payroll taxes on proceeds from the exercise of stock options. If the employer fails to report the compensation on your Form W-2, you must report it on your Form 1099 at tax time.