What Are Stock Options? And Do You Want Them?

In the earlier example, had Rachel sold the 100 shares of X stock on Nov. 10, 2004, the sale would constitute a disqualifying disposition (because the sale occurred within two years following the grant of the ISO). Accordingly, Rachel must recognize ordinary income equal to $1,000, which is the excess of the $2,000 fair market value of X stock upon exercise over the $1,000 strike price. Only the difference between the $2,500 sale price and the $2,000 fair market value upon exercise will be treated as capital gain.

Taxing the NQSO
As upon the grant of an ISO, an employee does not recognize income upon the grant of a NQSO. However, when the NQSO is exercised, the employee will recognize ordinary income equal to the difference between the fair market value of the stock when the NQSO is exercised over the strike price.

The transfer of a NQSO to a charitable organization is not a taxable event to the employee. However, the exercise of the NQSO by the charity will create a taxable event to the employee. This is because the employee will recognize income when the NQSO is exercised, even though the employee no longer owns the NQSO and doesn’t receive the stock. When the charitable organization exercises the NQSO, the employee will recognize ordinary income equal to the fair market value of the stock when the NQSO is exercised over the strike price. Unlike the transfer of other types of appreciated assets, in which a transfer to charity will enable the donor to avoid paying tax on the appreciation, the transfer of an NQSO requires the donor to pay the tax even though the stock is held by a charity. To add insult to injury, the charitable income tax deduction appears to be limited to the employee’s tax basis in the NQSO. Because the employee does not recognize income when the NQSO is granted, the tax basis is, as a rule, zero.