It's also crucial to understand that the sale of the securities will trigger another visit from Uncle Sam. If the employee sells the shares within a year following exercise, any appreciation since the exercise date will be considered short-term and taxed as ordinary income. If the securities are held for longer than a year, the capital gains tax kicks in.

ISOs are a different ball game. Usually reserved for the most senior executives, they must meet a variety of strict IRS criteria regarding shareholder approval, exercise limits and timing, among other requirements. They are treated differently from NQSOs for taxes.

Unlike an NQSO, an ISO does not trigger a taxable event when it is exercised. Taxes are instead triggered at the sale of the securities. This gives the executive a breath of tax-deferred air. If the ISO is held as stock for a year after exercise and two years after the grant, all gains will be taxed at long-term capital gains rates. Therein lies the big advantage of ISOs-the promise of tax-deferred gains ending in a lower rate after the sale.

It's not all peaches and cream for ISOs, however. Although the exercise is not a tax trigger, it is possible that the bargain element could be subject to the dreaded Alternative Minimum Tax (AMT). This particular issue is deserving of an article unto itself, but the point is that the AMT is a very serious hurdle and all executives and advisors need to understand the implications of it before exercising any ISOs.

Restricted Stock And 83b Elections
There's a relatively new kid on the block when it comes to stock awards. In the early 2000s, many of America's leading corporations began shifting away from the high-risk, high-reward universe of options and implemented a different system: restricted stock awards. This happened for a variety of reasons, including changes by Congress in the way options were taxed. Also employees wanted a more concrete, albeit possibly less rewarding, compensation structure.

The difference between restricted stock and stock options is relatively simple. While options give executives the right to buy a certain number of shares at a given price, they only have value if the stock is trading higher than the grant price. Restricted stock comes in the form of guaranteed, market-priced shares that are awarded according to a specified vesting schedule. There is no grant price, but executives are required to hold onto them for a good while before they're vested. Although restricted stock does not have the same mind-blowing upside potential of options, it comes with the security of knowing that there will definitely be some value-assuming the stock doesn't go to zero-when vesting occurs.

Restricted stock also has the advantage of involving fewer decisions than there are with options. No decision is required on when to exercise restricted stocks since shares are granted and received on a specified vesting date. The lack of choices can actually be a good thing since it makes it easier for the awardees to avoid the mistakes that can come with options.

The downside is that the simplicity of restricted stock means executives might put that portion of their awards on autopilot. If he does, he might miss one of the advantages of owning restricted stock: an IRS Section 83b election.

Here's how it works: When a grant of restricted stocks is made, holders can elect to be taxed at the current market value of those shares rather than the value at the time of vesting, even though they are not saleable yet. Why would anyone do this? Because making the election immediately starts the clock ticking on the capital gains clock, meaning any appreciation going forward will be taxed at the lower capital gains rate. If one were to wait, and see a dramatic increase in the stock price, the IRS would be looking for a much bigger piece of the pie when the stock vests.

So is there a possible downside to 83b? Absolutely. Imagine a situation where an 83b election was made, taxes were paid and subsequently the stock price dropped significantly. The executive would have then paid taxes on money he never saw, without the option of declaring a loss on his tax return. Or worse, what if he completely forfeited the stock for some reason? A pile of taxes would have been paid on something of zero value.