A stock option gives an employee or advisor the right to buy company shares at a fixed price (the strike price) later, regardless of what the shares are worth by then. Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) are the two main types, and they're taxed differently.
ISOs, available only to employees, can qualify for more favorable tax treatment (potentially long-term capital gains rates on the eventual sale) if specific holding-period rules are met, but they can also trigger the Alternative Minimum Tax on exercise even before any shares are sold. NSOs, which can go to advisors, board members, and contractors as well as employees, are taxed as ordinary income at exercise on the difference between the strike price and the current fair market value.
The strike price itself has to be set at or above the stock's fair market value at grant, which is exactly what a 409A valuation exists to establish. Getting that valuation wrong, or letting it go stale, is what turns a routine option grant into a real tax problem for the person receiving it.
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