Employee Stock Options

Originally utilized for American executives in the 1950s to avoid paying income tax, employee stock options have propelled early employees at Google, Apple, and Microsoft to millionaire status and have also caused personal financial crisis during market crashes. Employee stock options can be a great way to receive additional compensation, but knowing if you should exercise them, what that even means, and if they are valuable can be tricky.

What is it?

Employee stock options, simply put, are employers providing compensation to their employees through the ability to purchase stock (ownership) of the company at a set price, commonly known as the exercise price or strike price. There are two primary types of stock options:

• Incentive Stock Options (ISOs): ISOs are tax-preferred options that employers provide for key employees and top management. ISOs can’t be granted to individuals outside of the company.
• Non-qualified Stock Options (NSOs): NSOs do not have preferential tax treatment, but they can be offered to all employees as well as consultants. NSOs are also called non-statutory stock options.

These stock options allow employees to partake in the profits of the company, but there are rules about how you can exercise your options.

• Grant Date: This is the date at which the employer grants the options. Both the vesting period and the expiration date are based off of this date.
• Vesting Period: Most employee stock options have a vesting period. A vesting period is the amount of time before you can fully exercise your options. For example, if an employee was granted employee stock options of 1,000 shares with a vesting period of 1 year, she would have to wait for a year before she could exercise her option and purchase the 1,000 shares.
• Expiration Date: Employee stock options have an expiration date, usually 10 years after the options were granted to you. If you don’t exercise your options before then, they will expire and are no longer exercisable. Note: If you leave the company either voluntarily or involuntarily, your expiration date is sooner. For ISOs, you have 90 days to exercise your vested options. For NSOs, the new expiration date is decided by the company.

Early Exercise: Some employers allow their employees to exercise their options before they are fully vested. If an employee believes the company’s stock value is going to go up, early exercising can help them pay less in taxes if they file an 83(b) election. This election allows you to pay the taxes on the stock you purchase at the FMV on their grant date rather than on their vesting date. However, the stock that you purchase will still be unvested, and you will not have full ownership of the stock until it is fully vested. Note: A 83(b) election needs to be filed within 30 days of the grant date. If it is not filed, then you will have to pay taxes on when the stock vests.

Tips to Know:

• Some employee stock option agreements have a reload option, which allows you to be granted more options when you exercise your currently available options.
• Some employers allow a cashless exercise; rather than paying for the stocks in cash, you are able to sell some of your options back to the company to cover the cost of exercising the rest.

Paying Taxes on Options

When Exercising

If the fair market value of the stock is higher than the strike price of a NSO and an employee exercises their option, the employee will pay tax on the difference. This is because employee stock options are considered compensation given by the employer to an employee. Although the employee wouldn’t have received actual gains from exercising their option, the IRS considers it as a gain on paper (commonly referred to as phantom gain) and thus is taxable at their ordinary income rate. For example, an employee works for a company and has 100 vested NSOs at a strike price of $2. If the fair market value of the stock is $3 and the employee exercises their 100 options, they will pay $200 to purchase 100 stocks. Although they paid $200, the IRS values the stock at the FMV of $300. The phantom gain which the employee would pay tax on would be $100 ($300-$200). If the employee was in a tax bracket of 22%, she would owe the IRS $22 upon exercising her options. Note: For ISOs, the optionholder only pays tax on exercise if their income is above the alternative minimum tax threshold.

When Selling

After an employee has exercised their employee stock options, they now own the stock. Once they sell the stock, they will owe taxes if they sell it for a profit. If they have owned the stock for less than a year, they will be taxed at their ordinary income tax. However, if they have owned it for over a year, then they will be pay a long-term capital gains tax. Note: ISOs must be held for a year after exercising and for 2 years from the grant date to be taxed as capital gains rather than earned income.

Key Takeaways

Employee stock options can be a great bonus to receive from your employer. However, knowing whether to exercise them or not depends on your situation and the company’s prospects. Knowing what type of stock option you are being offered, the strike price of the option and the fair market value of the stock, and understanding your tax liability will help you understand how and if you should exercise your options.

If you have any questions on how to best prepare your family for the future, one of our advisers would be happy to help!