Although incentive stock options offer tax advantages to employees, they also come with a tax price for your company. For instance, the plan must meet numerous strict requirements spelled out in the law. In addition, the company gets no deduction at any time.

And to receive preferential capital gain treatment, option holders must retain the stock at least two years after receiving the option and one year after exercising it.

On the other hand, nonqualified stock options come with few strings attached. Your firm simply grants the options at a fixed exercise price to a select group of employees. As the employees exercise the options, the company claims a tax deduction for the difference between the fair market value and the exercise price. Of course, this amount is also taxable to the employees.

Best of all, the company isn’t burdened with the restrictions that can plague incentive stock options. For example, with an incentive stock option, the exercise price cannot be lower than the fair market value of the stock when the option is issued. There is no such restriction on nonqualified options.

It isn’t a slam-dunk by any means, but your tax adviser can help you compare the differences between nonqualified options and incentive stock options. You may be surprised at the result.

Stock Option Types

Nonqualified: Employees generally don’t owe tax when these options are granted. When exercising, tax is paid on the difference between the exercise price and the stock’s market value. They may be transferable.

Incentive: For employees, these options may qualify for special tax treatment on gains. Tax is deferred until they sell the stock. However, the income is considered a “preference item” for calculating the alternative minimum tax.