Stock options are a form of equity compensation that gives the holder the right to purchase shares of a company’s stock at a specific price (called the exercise or strike price) at a future date. The holder of a stock option has the right, but not the obligation, to buy the shares at the exercise price. There are two main types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs).
Incentive stock options (ISOs) are options that are granted to employees and are eligible for special tax treatment under the Internal Revenue Code. If the holder of an ISO meets certain holding period and other requirements, they will not be subject to ordinary income tax when they exercise the option. Instead, they may be subject to capital gains tax when they sell the shares.
On the other hand, non-qualified stock options (NSOs) are options that are granted to employees, independent contractors, and directors, and are not eligible for the special tax treatment that ISOs receive. When the holder of an NSO exercises the option, they will be subject to ordinary income tax on the difference between the fair market value of the shares at the time of exercise and the exercise price.
Stock options are often granted as part of an employee’s compensation package. They can be used as a form of long-term incentive compensation, aligning the interests of employees with those of shareholders by giving employees a stake in the company’s success.
In accounting and financial statements, stock options are recorded as an expense, and the company will record an expense over the vesting period, reflecting the service condition of the award. This expense is calculated using the fair value of the options on the grant date, which is an estimate of the expected price of the underlying stock at the time of exercise.
Overall, stock options can be a valuable form of compensation for employees, providing them with a direct financial interest in the company’s performance and potential for appreciation in the value of the shares.
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