There are qualified (a.k.a. “incentive”) stock options plans as well as non-qualified stock option plans. The basic difference is that incentive stock options receive special tax treatment, which is better from an employee’s perspective, but not necessarily from the company’s.
Incentive stock options are available for issuance only to employees. No income is reported when the employee exercises the option (with some AMT considerations), and the entire gain when the stock is sold can be taxed as long term capital gains (instead of regular income). Also, incentive stock options must be nontransferable, and exercisable no more than 10 years from grant, with an exercise price at least equal to the FMV at time of grant.
Non-qualified stock options result in taxable income to the recipient at the time they are exercised in the amount of the difference from the exercise price and the market value when exercised. Employers prefer non-qualified stock options because the company receives a tax deduction equal to the amount the stock receipient is required to include as income – the company is not allowed this deduction when using incentive stock options. Nonqualified stock options are issuable to anyone, may or may not have an exercise price and are transferable. We’ll explore the details in later posts.