A Basic Guide to Employee Stock Options

When companies grant stock options to their employees, the recipient gains the right to purchase shares of the company at a fixed pre-determined price (called the strike price or exercise price) at any point before the option reaches its pre-set expiration date.

To illustrate how this works in practice, let’s walk through a common example. In 2014, Sharon received options for 100 shares of her employer’s stock, when the company’s shares were trading at $2.35 per share. Her grant came with a $10 per share strike price and an expiration date of December 31, 2023. When Sharon decided to exercise her options near the end of 2023, the company’s stock was trading at $20 per share. At this point, her options are considered “in the money,” which simply means the fixed strike price is lower than the stock’s current market price at the time of exercise.

Sharon’s profit comes from the spread between her total exercise cost and the current value of the shares. Her total exercise cost equals $1,000 (100 options multiplied by the $10 strike price), while the 100 shares are worth $2,000 at exercise. After exercising her options, Sharon can choose between two paths: she can continue holding the shares in the hope that the price will rise further, or sell immediately to lock in her profit.

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How Are Employee Stock Options Taxed? It Depends on the Option Type

There are two primary categories of employee stock options: incentive stock options (ISOs) and nonqualified stock options (NSOs). This classification makes a huge difference in how your options are taxed, which in turn often shapes the strategy you use to manage your grant.

Nonqualified stock options (NSOs) are taxed at your ordinary income tax rate in the year you exercise the options. By contrast, gains from incentive stock options (ISOs) are not taxed as ordinary income at the time of exercise — unless you sell the shares the same year you exercise. Instead, employees can access a major tax benefit by holding shares after exercise: if you meet the required holding period, your profit will qualify for the lower long-term capital gains tax rate when you eventually sell.