A: Stock plans usually work in similar ways. Here is a step-by-step description of the stock option process.

1. You are granted stock options.
Lucky you. A company, whether public or private, grants an employee an option for shares at a certain price per share. These options might be granted when you join the company or after you've been there for a period of time (maybe six months or a year). When a company "grants," it promises that if you stick with them, you'll receive a set number of options over the course of your career there. The number of options you receive is usually based on a percentage of your salary or your perceived value to the organization.

2. Your options vest.
Not so fast. Employees typically do not own the stock outright when options are granted. Stock options vest (or become yours to exercise) over a period of time, usually a number of years during which you stay with the company and presumably work hard at helping the organization increase its worth. In other words, you earn them over time. If, for example, you are an employee of The Motley Fool Inc., a privately held company in Alexandria, Va., your options are granted after you are there for six months and will vest typically at the rate of 20 percent per year. Additionally, each year you are employed with the company, you should have the opportunity to earn additional options for more shares, which will also vest over time.

3. You exercise.
After the shares are fully vested, this means you almost own them, but alas not yet. You have to convert the options to shares by buying them for the option price the company offered you. Buying the shares is known as "exercising your options." After you buy, you can either hold the stock in your portfolio -- hoping for more appreciation -- or sell the stock to realize an immediate gain. If unluckily, the stock price drops below your option price, you need never exercise your options.

4. You sell.
If the stock price has happily risen above your option price, you are free to sell, make that pot of money, purchase that Porsche and live high on the hog. But before you rush off, don't forget that Uncle Sam will also share in your new wealth and demand taxes on that gain.

A: Essentially stock plans fall into three categories:

• (1) incentive (statutory) stock option plans,

• (2) nonqualified (non-statutory) plans, and

• (3) shadow (phantom) plans.

Each has a different tax treatment, which is important to remember in calculating the value and tax implications of your option action plan. Since as of this writing, current ordinary federal income tax rates ranged up to 39.6 percent, and long capital gains tax rates have decreased to 20 percent, it's probably in your best interest to aim for capital gains tax treatment if possible. This means that the timing of when you exercise and when you sell your options could be key. Below we examine the tax ramifications for each of the three most common plans.

(1) Incentive/Statutory Plans
According to Tim Jessell, who specializes in helping companies formulate their stock plans at the Washington, D.C., law firm, Ginsburg, Feldman and Bress, "Typically, statutory or incentive stock option plans are offered to their employees by large, publicly traded companies." No tax is due on the exercise of the option. The gain -- the difference between the value of the stock when you actually sell it and your option price -- enjoys capital gains treatment upon the sale.

Say your option price is $10 per share, and you exercise your option when the stock has a value of $22 per share, you don't owe taxes on the $12 per share difference when you exercise. But if you then sell the stock at $22 per share, you will pay capital gains tax on the $12 gain. With statutory stock option plans, Jessell says, "the employer enjoys no tax benefit but gets happy employees, so this plan is typically done with larger public companies."

(2) Nonqualified (Non-statutory) Plans
If your company only offers a nonqualified stock plan, don't fret; it doesn't mean the stock plan is illegal. A nonqualified plan (which a company might offer in addition to the above-mentioned incentive plan) not only lets the company offer stock to employees at very cheap prices, but also creates some tax benefits for the company that an incentive plan does not. With nonqualified plans, you need to be much more careful about when you exercise your options, because the tax ramifications here carry far greater consequences.

For this example, let's assume you participate in a nonqualified plan and have 10,000 stock options priced at $0.25 per option. If the stock is worth $2 per share when you exercise the option and convert it to shares, you will buy it for $2,500 (10,000 x $0.25) and then own stock worth $20,000 (10,000 x $2). You will pay ordinary income tax on the $17,500 gain from exercising your options. Let's also assume you hold the stock and it continues to appreciate in value to $20 per share. Then, when you sell the shares, the same tax rules for incentive plans apply; you will enjoy capital gains tax treatment on the $180,000 gain.

Waiting until the stock was worth $20 per share to exercise your options, however, would have destroyed you tax-wise. You would have been taxed at the ordinary income tax rate on the $197,500 ($200,000 minus $2,500) gain, and none of it would have enjoyed the lower capital gains tax rate treatment. The moral of the story, option exercisers, is that you want to own the stock shares before the value of the shares gets too high. So timing is everything here.

(3) Shadow (Phantom) Plans
Closely held or "Mom and Pop" companies use shadow plans as incentive compensation to reward loyal employees. A phantom stock plan usually gives the employee the benefits of stock ownership without the cost and risk of actual ownership. Under most plans an employer will credit an employee's account with hypothetical "phantom" stock and then at a certain date in the future the employee is entitled to receive the difference between the market share value and the phantom share value. This payment -- sometimes received in installments -- is taxable as ordinary income.

From the company's perspective, says Tim Jessell, "these are really no different from any other salary or cash bonus plan. They let the employer receive deductions for the cash payments they make to the employees under the plan," while rewarding the employees based on the increase in value of the employer's stock. Also, as Scott Spector points out, "such a plan is not as attractive if the company is about to go public since the employee may not benefit from the pop that the market gives to the stock upon a public offering."

A: If, as part of your new employee compensation package you are granted stock options, there are a few basic questions you might want to ask. First, you should know the price of the shares in your option and how well (or poorly) the stock has performed over the last year or two. Then, you want to ask what type of stock plan (statutory, non-statutory, or shadow) they are offering. You should then consider the tax treatment applied in the exercising of your options and the potential restrictions on the sale of your stock. Obviously, you are looking for a stock plan that lets you enjoy the most favorable capital gains tax treatment.

Next, you should ask about the vesting process: Does your option vest only after a period of years or is the vesting schedule based on "performance"? If it is performance-based, are they measuring your individual job performance or to the company's performance?

You should also hope that if you were to leave the company, there would be a public market for your shares (as there would be in any publicly traded company). If you are taking shares in a company before it goes public, you might ask if you are restricted to selling the shares back only to the company and if so, at what price? Similarly, inquire as to what happens to your options if the company goes public or is acquired? Will you have fully vested options at that point? "If the company is sold or goes public," states Tim Jessell, "you want the ability to participate in that and you want your options to vest immediately."

Of course, no matter the size of the company or the stock plan it offers, you could wind up with stock that is worthless. So if you sense that the company is fragile and you know from the outset that you'd rather have the cash, then ask for it. Instead of stock, please just show me the money.