Most workers receive only a salary for their work, but some are fortunate enough to receive stock options as well. Employee stock options can dramatically increase your total compensation from your employer, but they also have tax consequences that can complicate your return. What tax rate you pay when you exercise stock options depends on what kind of options you receive.

Incentive stock options vs. nonqualified stock options
There are two types of employee stock options. If your employer follows certain rules, then you can receive incentive stock options, which have favorable tax characteristics. In order to issue an incentive stock option, your employer must grant options to employees under both a general plan document covering the entire company and a specific option agreement with each employee receiving options. The option can have a maximum term of 10 years, and the exercise price must be at or above the current share price when granted. If you leave your employment, then you must exercise the option within three months of your termination date.

The reward for incentive stock options is that you don't have to pay any tax on the difference between the exercise price and the fair market value of the stock you receive at the time you exercise the option. In addition, if you hold the stock for a year after you exercise -- and at least two years after the date you received the option -- then any profit is treated as long-term capital gains and taxed at a lower rate.

Why nonqualified stock options aren't as good as incentive stock options
If the option doesn't meet the requirements of an incentive stock option, then it's taxed as a nonqualified stock option. In that case, you have to pay income tax at your ordinary income tax rate on the difference between the exercise price and the fair market value of the stock you receive at the time you exercise the option. That paper profit is added to your taxable income even if you don't sell the shares you get when exercising the option.

When you later sell your shares, the tax rate you pay depends on how long you hold the shares. If you sell the shares within a year of when you exercised the option, then you'll pay your full ordinary income tax rate on short-term capital gains. If you hold them longer than a year after exercise, then lower long-term capital gains rates will apply.

The key in stock option tax treatment is which of these two categories includes what you got from your employer. Talk with your HR department to make sure you know which one you have so you can handle it correctly.

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