A great way to acquire and retain talented and skilled employees is to offer them stock options. Usually, businessmen who are successful in certain fields are hot commodities for large corporations who are looking to expand in the same field. Instead of training in-house, they want to hire someone from outside who already has the skills and the experience to come and help them grow. These individuals are not usually looking for just a salary, they want incentives and a large corporation that is about to expand and increase its value in the market, and stock options are the best choice for an incentive. There are two types of employee stock options available today.
ISO, incentive stock options, also known as statutory stock options, are only available to employees of the company and receive favorable treatment from the IRS. You dont have to pay taxes on the stock options until you sell the stocks. And even then if you follow certain guidelines, like holding them for over an year, making them long term gains and at least for two years after you exercised them, you only pay low capital gains tax, not the same as income tax which is according to your income bracket. Also you dont owe any Medicare or social security tax on the spread which is the difference resulting from the grant price (when you were given the options) and when you exercised the options. For example, you were granted 5000 stocks at $10 a piece, when you exercise them they are $50 a piece. The difference is $200,000. You dont pay any social security or Medicare tax on this amount.
Requirements for the ISO are:
NSO, non-statutory stock options, are available to employees and others that at one time or another are hired by your company to do contractual jobs. A good example would be an outside agent or an independent contractor. The company does not directly employ them. They dont receive benefits and retirement packages that your employees would. This is the main difference between the two stock options.
The other has to do with taxes. For reasons known only to IRS, NSOs are taxed differently then ISOs. At the time of the exercising of the option, if the exercise price is greater than the grant price like in the example stated about, the optionee owes IRS Medicare and social security taxes on this amount. This is the case regardless of whether the optionee still owns the stocks or not. Also the optionee might face a higher capital gains tax when he or she sells it unless its held over one year after the option was exercised, then the stocks become long-term gains and the tax is reduced. So hold on to your NSO for a longer period of time to save yourself some taxes.