What Are Stock Options? And Do You Want Them?

Stock options are a source of significant wealth — both the options themselves and the stock acquired upon the exercise of the option can be valuable assets. But stock options do not always lend themselves to effective charitable giving. They’re subject to complex taxation rules and, to a lesser extent, rules under the Securities Exchange Act of 1934. It’s important to understand when and to what extent these assets make effective charitable gifts.

Stock options are the right to acquire shares of stock at a set price (the “strike price”) for a specified period of time. For instance: An employer might grant an employee the right to acquire 100 shares of stock at $10 a share for a five-year period. If the price of the stock goes up to $25 per share during this five-year period, the value of the right to purchase a share of stock at $10 also increases.

There are two types of stock options: incentive stock options and non-qualified stock options. ISOs have income tax advantages to the owner of the stock option, which NQSOs are not afforded. On the other hand, NQSOs are not subject to certain limitations that apply to ISOs. NQSOs also provide the employer with a deduction, which ISOs generally do not.

The ins and outs of income tax
When an employer grants an ISO to an employee, no income tax is recognized at that time. The exercise of the ISO by the employee is not an income tax event for the regular income tax either. However, the spread between the strike price and fair market value of the stock at the date of exercise is a tax preference item for alternative minimum tax purposes and can create an alternative minimum tax liability. If the alternative minimum tax does not apply, and the ISO holding period rules are met, only when the employee sells the stock acquired by the exercise of the ISO will an income tax be triggered. The tax will be on the difference between the strike price and the sale price. An example of the ISO rules is as follows.