What You Need to Know About Employee Stock Options
If you work for a large company, it’s likely that you have the opportunity to take advantage of a comprehensive benefits package. Understanding all of the perks that you are entitled to is crucial to your long-run financial success. One perk I’d like to highlight is Employee Stock Options (ESO). Through my explanation of the ins-and-outs of ESO’s, you will have a better understanding of how you can make the most of them.
WHAT ARE EMPLOYEE STOCK OPTIONS?
ESO’s offer the holder the right to buy a certain amount of company shares at a predetermined price for a specified period of time. Employees are given a share in the potential growth of their company’s value, without actually risking their own money – until they decide to exercise those options and purchase shares of the company’s stock.
HOW DO EMPLOYEE STOCK OPTIONS WORK?
Let’s say you work for Company XYZ, and they have issued employee stock options to you at $50. In this scenario, you would have the right to purchase 1,000 shares of XYZ stock at $50 (the grant price) after three years (the vesting period) and within ten years (the expiration date) of the grant date.
Taking the example above, what happens if, after four years, the market price of XYZ is at $100? In this case, you can purchase 1,000 shares at $50, then sell them at the $100 market price – pocketing a $50,000 profit!
Alternatively, if after four years, the market price of XYZ is at $25? At this point, you would not have to buy the shares at a loss. Instead, you can wait until the 10-year expiration date for the stock price to potentially surpass the grant price.
WHAT ARE THE DIFFERENT TYPES OF EMPLOYEE STOCK OPTIONS?
There are two types of ESO’s that a company can grant: (1) Non-qualified Stock Options (NQSO’s) or (2) Incentive Stock Options (ISO’s). NQSO’s are the most common type offered by employers.
Non-qualified stock options (NQSO’s) do not qualify for special tax treatment, and result in additional taxable income to the recipient at the time that they are exercised, the taxable amount being the difference between the grant price and the market value on that date. In addition, when NQSO’s are exercised, income, Social Security, and Medicare taxes will be withheld.
In contrast, Incentive Stock Options (ISO’s) qualify for special tax treatment and are not subject to Social Security or Medicare withholding taxes.
WHAT IS THE TAX TREATMENT OF EMPLOYEE STOCK OPTIONS?
As discussed above, it is clear that NQSO’s and ISO’s are treated differently when it comes to taxation. However, for both types, the grant of the option itself is never considered a taxable event.
For NQSO’s, taxation begins at the time that the option is exercised. Once exercised, the purchase of discounted stock is considered “compensation” and is taxed at ordinary income tax rates. When those purchased shares are sold, either short-term or long-term capital gains taxes may be owed. With short-term capital gains, the employee would be subject to tax at their ordinary income tax rates. With long-term capital gains, the tax would be significantly reduced.
Gains on ISO’s are not subject to payroll taxes. However, ISO’s are a preference item for the alternative minimum tax (AMT) calculation. Also, if you exercise and sell the stock within a year, you will pay ordinary income tax on the difference between the market price at sale and the grant price, much like the treatment of NQSO’s.
When you exercise the ISO but hold the stock, tax treatment can get quite complicated. In this situation, the difference between the grant price and the market price then becomes an AMT preference item, so exercising ISO’s might mean you’ll pay the AMT. If you hold the shares for one year from exercise date (and two years from the grant date of the option), the difference between grant price and market price when you sell the option is taxed as lower long-term gains rather than ordinary income.
HOW SHOULD EMPLOYEE STOCK OPTIONS FIT INTO YOUR FINANCIAL PLAN?
It is important to think of your ESO’s in the context of your overall financial plan. First and foremost, your financial plan should be based on clearly defined goals for yourself and your family. Once you have your goals set, how can ESO’s best help you reach them? This is never an easy question to answer, but the more you understand about the ESO’s at your company and their future growth potential and taxation, the better off you will be.
Richard Archer is a financial advisor and the President of Archer Investment Management with more than eighteen years of industry experience. Largely working with successful executives and business owners, he specializes in providing comprehensive investment guidance and personalized care and attention to each client. Along with holding a Bachelor of Science in Economics and an MBA from the University of Texas, he is a CERTIFIED FINANCIAL PLANNER™ certificant and a Chartered Financial Analyst®. He combines his advanced industry education and knowledge with his genuine care for people to provide clients with an exceptional experience. To learn more about Richard, connect with him on LinkedIn or visit www.archerim.com.