Employee Stock Options

There are three classes of stock options--incentive stock options, employee stock purchase plan options, and nonqualified (nonstatutory) stock options.

Generally, for income tax purposes, incentive stock options and employee stock purchase plan options are excluded from wages both when the options are granted and when they are exercised (unless the stock is disposed of in a disqualifying disposition). However, the spread (between the exercise price and fair market value of the stock at the time of exercise) is included in wages subject to social security, Medicare, and federal unemployment taxes when the options are exercised. Income tax withholding is not required at the time of exercise.

The spread on nonqualified options normally is included in wages for income tax purposes when the options are exercised. (See section 1.83-7 of the regulations.) The spread on nonstatutory options is also subject to social security, Medicare, and FUTA taxes, and income tax withholding at the time of exercise.

The IRS will not enforce the application of social security, Medicare, and FUTA taxes at the time of exercise on the spread on incentive stock options and employee stock purchase plan options, for exercises that occur before January 1, 2003. In addition, if stock acquired pursuant to the exercise of an incentive stock option or employee stock purchase plan option that occurred before January 1, 2003, is subsequently sold in a disqualifying disposition, the income is not subject to income tax withholding. However, the income should be reported to the employee or former employee, generally in box 1 of Form W-2. See Notice 2001-14 (2001-16 I.R.B. 516) for more information.

For more information about employee stock options, see sections 421, 422, and 423 of the Internal Revenue Code and the related regulations.

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