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Well, capital gains ARE part of income. So it's not an either/or situation.

If you exercise the options and hold the stock for at least a year (or until 2 years from the option grant if that is longer), you can get capital gain treatment. Otherwise, it's all ordinary income and will be included on your W-2.

The tricky part about reporting is that you'll also need to report the sale of the stock on your return, but that will have virtually no gain or loss (typically it's a small loss in the amount of some transaction fees, but sometimes there will also be a change in the price of the stock between the exercise of the option and the sale of the stock.)

If you don't report correctly, you'll get a nasty letter from the IRS a year or two after you file asking for a very large sum of money. You'll then spend weeks in bureaucratic purgatory fixing things up, all the while receiving more threatening letters.

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