Stock Options (Employee)
The right granted to employees to purchase company stock at a predetermined price (strike price) within a set period.
What is Stock Options?
Employee stock options (ESOs) give employees the right — but not the obligation — to buy company stock at a predetermined price (the strike or exercise price), typically at or below the market price at grant date, within a specified period (usually 10 years). Options vest over time (commonly over 4 years) to incentivize retention. Two types exist for tax purposes: Incentive Stock Options (ISOs), available only to employees and eligible for favorable tax treatment; and Non-Qualified Stock Options (NSOs), which have different tax consequences. The value of options depends entirely on the stock rising above the strike price — if the stock never exceeds the strike price, the options are 'underwater' and worthless. Stock options were the dominant form of equity compensation in the 1990s tech boom.
Example
An engineer at a startup receives options to buy 10,000 shares at a strike price of $5/share, vesting over 4 years. Five years later, the company goes public at $30/share. The engineer exercises their fully-vested options: pays $50,000 (10,000 × $5) to receive shares worth $300,000, realizing a $250,000 gain — subject to ordinary income tax if NSOs or AMT rules if ISOs.
Source: IRS — Publication 525, Taxable and Nontaxable Income