The main difference between an incentive and a nonqualified stock option is how they are taxed.

An incentive stock option or ISO qualifies for special federal tax treatment. After you exercise an ISO, if you hold the stock for at least one year from the exercise date and two years from the grant date, your profit will be taxed at the lower long-term capital gains rate. However, you may be subject to alternative minimum tax.

A nonqualified stock option does not qualify for special tax treatment. Most rank-and-file employees receive this type of option. When you exercise a nonqualified option, your gain will be taxed as ordinary income in that tax year, whether or not you continue to hold onto the stock. Most people exercise their options and immediately sell at least some of them, to cover this tax bill. If you continue to hold shares for at least one year after you exercise, the difference between the market price at the time of exercise and the price you receive when you eventually sell the stock will be taxed as a long-term capital gain. Nonqualified stock options are not subject to alternative minimum tax.

For more information, see www.mystockoptions.com.