The world of employee stock ownership plans, stock option plans, employee stock purchase plans, and incentive option plans is confusing at best, and it's difficult if not impossible to evaluate the potential worth of stock and stock options offered by your employer. Stock options are a popular method of attracting employees in high-tech companies and are becoming more common in other industries as part of total compensation plans.

Stock Options

Stock option plans are a way for companies to attract, share ownership with, and reward employees. The days of average employees getting rich on stock options may be over, but stock options can still be a worthwhile benefit. Most people have heard lots of talk about stock options during the heyday of high-tech growth in the late 1990s, but few people really understand what they are and how they work.

A stock option gives an employee the right to buy company stock at a specified price during a specified period after the option has vested. Companies use the vesting period to motivate employees to stick around. Let's say you receive an option on 500 shares at $10 per share and the stock price goes up to $20. You can exercise the option and buy the 500 shares at $10 each, sell them for $20 each, and pocket the $5,000 difference. If the stock price never rises above the option price, you don't lose money but you don't make any, either. You simply don't exercise the option.

Employee Stock Purchase Plans

Employee stock purchase plans (ESPPs) offer employees the chance to buy stock, usually through payroll deductions during an “offering period” at a discounted price. The employee can then sell it right away and take the profit created by the discount, or hold on to it in expectation that its value will increase.

Employee Stock Ownership Plans

Employee stock ownership plans (ESOPs) are a type of benefit plan that is regulated by the federal government in which a trust is set up to acquire some or all of the stock of the company and sell the stock to employees. Because ESOPs receive tax advantages, they're not allowed to discriminate in favor of key or highly compensated employees, so most employees get to participate.

ESOPs are typically used as a type of retirement plan, or as an exit strategy for the boss in small companies. Be cautious about investing the bulk of your retirement funds in company stock no matter how well established the company is. Take advantage of employee ownership but spread out your risk by putting most of your retirement money in other investment options.

Incentive Stock Options

Incentive stock options (ISOs) allow employees to purchase shares of stock at some time in the future at a specified price. The employee pays tax on the gain upon sale or disposition of the stock, not upon receipt or exercise of the option. Nonqualified stock options don't have the restrictions of other options and don't receive any special tax consideration. When employees exercise nonqualified options, they pay ordinary income tax on the difference between the grant price and exercise price.