It’s my annual “Taxes from A to Z” series! If you’re wondering whether you can claim wardrobe expenses or whether to deduct a capital loss, you won’t want to miss it.

K is for Strike Price.

Okay, this one is a bit of a trick. The financial world loves abbreviations and symbols: that makes it easy to express terms in mathematical formulas. One of those symbols is a K for strike price.

(As an aside, I did attempt to find out the historical reason for the K and I’ve had no luck. I’ve run across suggestions that it’s tied to baseball or from the Greek word for strike but nothing concrete. If you know, I’d love to hear from you!)

So what is a strike price? The strike price is the exercise price of an option. In simple terms, it’s the price at which the option will be bought (for a call option) or sold (for a put option).

Options on the markets can be pretty dense topics. For our purposes, we’re going to focus on the kind of options that most taxpayers are familiar with: employee stock options. Here’s what you need to know.

When you receive stock options as an employee, you have the right but not the obligation to buy up to a specific number of shares of company stock at a fixed price (the strike price) during a specific time period (the exercise period). The strike price is fixed: it won’t change even if the fair market value of the stock moves up and down. The goal is, of course, to have a fair market value worth more than your strike price.

The tax treatment of stock options depends on what kind of options you receive. Incentive stock options (ISOs) are the most tax-favored. If you follow the rules, the exercise of an ISO doesn’t result in immediate federal income tax. However, when you sell the stock, you do trigger federal income tax – and this is where the strike price matters. When you sell your stock, you will have a capital gain. You’ll figure the gain by subtracting the cost basis (in this case, the strike price) from selling price.

(Additional rules and restrictions may apply. It’s also worth noting that the exercise of ISOs can trigger alternative minimum tax (AMT).)

If you don’t follow the rules, you’ll lose the tax-favored treatment and be subject to ordinary income tax on the difference between the fair market value of the stock and the strike price.

If all of this is making your head spin, you’re not alone. Figuring out stock options can be challenging. It’s a good idea to consult with a tax professional for more information about your specific circumstances.

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Author

Kelly Erb is a tax attorney and tax writer.

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