Tax considerations of employee stock options
By Laura Bruce • Bankrate.com

Let's take a look now at some of the basic tax situations that stem from exercising and/or selling employee stock options.

Nonqualified stock options
There's a bit of a double whammy when exercising nonqualified stock options. You pay the exercise price plus you pay taxes on the bargain element -- the difference between the exercise price and the fair market value at exercise.

For example, you exercise 100 shares of stock. Exercise price is $15 per share. Fair market value at time of exercise is $35.

At time of exercise you pay $1,500 to cover the exercise price (100 shares x $15 = $1,500).

You also pay your ordinary tax rate on the bargain element; in this example, the bargain element is $20 per share (100 shares x $20 bargain element = $2,000).

Expect to pay your ordinary tax rate on the $2,000 profit.

If you continue to hold shares, but sell them in less than one year, you'll pay ordinary taxes on any appreciation above $35 per share. Hold the shares longer than one year, and you'll pay long-term capital gains tax on any gain above $35 per share.

Incentive stock options
For example, you exercise 100 shares of stock. Exercise price is $15 per share. Fair market value at time of exercise is $35. The share price when you sell is $60.

If you hold the shares in your account for one year or more before selling, you pay long-term capital gains tax on $4,500 ($60 - $15 = $45 x 100 = $4,500).

If you sell the shares before holding them for one year, you'll pay ordinary income tax on $2,000, the difference between the fair market price at the time you exercised your options and the exercise price ($35 - $15 = $20 x 100 = $2,000).

You then pay short-term capital gains tax on $2,500, the difference between the share price of the stock when you sold and the fair market price when you exercised ($60 - $35 = $25 x 100 = $2,500).

If the share price falls below $15, and you sell your shares, you'll have a capital loss.

Alternative minimum tax, or AMT
The exercise price is $15 and the fair market value at time of exercise is $35. The $20 spread between them is the bargain element. Since you're exercising 100 shares, the amount subject to AMT is the $2,000 bargain element.

You must decide by Dec. 31 whether to sell or hold those shares, because the amount owed in AMT will be irrevocable after that. If the share price drops before the end of the year to $20 you will still owe tax as if the shares were at $35 if you hold the shares into the new year. The way to get around that and only pay on the true gain is to sell the shares before the end of the year.

Read more about "Understanding employee stock options."