DEFINITION of Statutory Stock Option

A statutory stock option (also known as an incentive stock option) is a type of employee stock option that gives participants an additional tax advantage that unqualified or non-statutory stock options do not. Statutory stock options require a plan document that clearly outlines how many options are to be given to which employees, and those employees must exercise their options within 10 years of receiving them.

Furthermore, the option exercise price cannot be less than the market price of the stock at the time the option was granted. Statutory stock options cannot be sold until at least a year after the exercise date and two years after the date the option was granted.

BREAKING DOWN Statutory Stock Option

The taxation of statutory stock options can be somewhat complicated. The exercise of statutory stock options will not result in immediate declarable taxable income to the employee (one of the chief advantages of this type of option). Capital gains tax is then paid on the difference between the exercise and sale price. This type of option is also considered one of the preference items for the alternative minimum tax.

How Statutory Stock Options Are Handled for Tax Purposes

According to the Internal Revenue Service, when employers grant their employees statutory stock options, the employee typically does not include any amount in their gross income when they receive or exercise the option. Despite that fact, employees who receive a statutory stock option may fall under the alternative minimum tax for the year their incentive stock options are exercised.

When the stock that was acquired through exercising the option is later sold, the employee will have a taxable income or a deductible loss as a result. This is typically rated as a capital gain or loss. The assumption is that the price of the stock option will be lower than the market price at the time the option is exercised, which would allow the employee to possibly sell the asset for a profit.

If the employee does not meet special holding period requirements – meaning he or she sold the shares before one year passed since the exercise date – the income from that sale must be handled as ordinary income. That amount is also added to the basis of the stock in order to calculate the loss or gain on the disposition of the stock.

With an employee stock purchase plan, after the stock acquired by exercising an option is transferred or sold for the first time, they should furnish forms from their employer that include information for determining the ordinary and capital income that must be reported.