Employee Stock Options 101
Many companies today offer their employees the ability to purchase shares of stock in the company by granting stock options as a form of compensation. Stock options are beneficial to both parties, as it allows employers to attract and retain high-quality employees, while providing a nice additional benefit for employees. While stock options can be a great potential benefit, many employees are not very familiar with how they work. The goal of this article is to help you better understand what stock options are and how they work, what types of stock options there are, and how to maximize them for your benefit.
What are Stock Options?
So, what exactly are stock options? Stock options allow an individual to purchase a specific number of shares of company stock at a specific price within a specific period of time. Should the individual choose not to exercise the options by the end of the stated time period, the options expire and become worthless.
For employees of a company that grants stock options as part of their benefits package, the granted options can end up being a valuable part of their compensation package. If the price of company stock appreciates substantially while an individual is holding options, he/she can purchase shares at a significant discount and can then either choose to hold on to the stock for the long-term or immediately turn around and sell the stock on the market for a profit. If, however, the stock of the company declines in price over the option holding period to the point where it would be more expensive to use the options then just purchasing the stock on the market, then the employee can choose to let the options expire.
Important Dates and Terminology Surrounding Stock Options
If you want to better understand how stock options work, there are several dates and some basic terminology that you need to become familiar with, as outlined below.
Important Dates
Issue/Grant Date – the date when the employer gave the stock options to the employee
Vesting Date(s) – The earliest date that the granted options can be exercised by the employee and redeemed for stock at the agreed upon price. Options can be redeemed at any point between the vesting date and the expiration date of the options. (see “Vesting” section below for more information)
Exercise Date – when the employee “exercised” the stock option and bought the stock at the agreed upon price
Expiration Date – the date at which the employee can no longer exercise the options
Sale Date – The date when the employee sells the stock. This is important to know for tax purposes.
Additional Terminology
Market Price – the current price that the stock is being sold for in the stock market
Strike Price/Exercise Price/ Grant Price – The agreed upon price that the employee will purchase the stock, should he/she choose to exercise the options.
“in the money” – An option is said to be “in the money” if the current market price of the stock is above the strike price of the stock option. For example, a stock option that has a strike price of $35 per share while the market price is $40 per share would be considered in the money, but a stock option that has a strike price of $45 with the same market price would be considered out of the money.
Vesting
Most stock option plans have some sort of vesting schedule that requires employees to work at the company for a certain period of time (usually at least a year) before exercising their options. Some vesting schedules are cliff vesting schedules where all options vest on a specific date. Other vesting schedules are graded and will allow a percentage of options to vest each year until the employee is 100% vested. Should the employee leave the company prior to all of his/her options becoming vested, then he/she forfeits all remaining unvested shares.
Two Main Types of Stock Options
There are two common types of stock options: Non-Qualified Stock Options (NQSOs) and Incentivized Stock Options (ISOs).
Non-Qualified Stock Options
The majority of employees that have stock options through work have Non-Qualified Stock Options. With NQSOs, there is no taxes due when the company grants the options to the employee, but when the employee chooses to exercise the options, then he/she must treat the difference between the strike price and market price of the stock as ordinary income and be taxed accordingly. Generally, your employer will withhold the income tax, Social Security tax, and Medicare tax for you when you exercise your NQSOs. Should the employee hold on to the stock after exercising the options, then the additional gains (or losses) will be treated as capital gains (or losses) at the time of sale of the stock.
Example
Leroy is granted 100 Non-Qualified Stock Options by his employer XYZ Corporation to purchase company stock at $150 a share. After his NQSOs have vested, Leroy exercises all of his options and purchases 100 shares of XYZ stock when the current market price for the stock is $225 a share. As a result of the transaction, $7,500 (($225-$150) x 100) will be added to Leroy’s taxable income for the year.
After exercising his stock options, Leroy holds onto the stock for an additional three years, then sells the stock when the market price is $250. Assuming Leroy is in the 15% capital gains bracket, Leroy will have a long-term capital gain from the transaction of $2,500 (($250-$225) x 100) and will pay $375 ($2,500 x 15%) in long-term capital gains taxes for the year.
Incentive Stock Options
Incentive Stock Options (ISOs) are a less common form of option that is usually seen in executive compensation plans. With ISOs, no income tax is due when options are granted or when they are exercised. Rather, taxes are deferred until time of sale. If an individual holds onto the stock for at least two years from the grant date and one year from the exercise date, then he/she will pay long-term capital gains tax rates on appreciation over the exercise price from the sale of stock. If the individual sells the stock within two years from the grant date or one year from the exercise date, then any gains will be taxed at ordinary income tax rates.
Example
In January 2016, Jerry was granted 1,000 ISOs of company stock at $25 a share. A year later in January 2017, Jerry’s options vested and he subsequently exercised all of the options at $35 a share. In May 2018, Jerry sells all of his stock for $45 a share. Because Jerry waited over a year from the exercise date and two years from the grant date, the entire sale of Jerry’s stock is taxed at the more favorable capital gains rates. Jerry will pay capital gains tax on the difference between the exercise price ($25) and the price at which the stock was sold ($45). Assuming that Jerry is in the 15% capital gains tax bracket, he will pay $3,000 ($20 difference between exercise price and price at which stock was sold x 1,000 shares x .15) in capital gains tax on the transaction.
After Exercising the Options, Should I Sell or Continue to Hold the Stock?
While the right choice will vary from person to person, what we tell our clients is that you should avoid, if possible, a concentrated position in any individual stock holding. We define a concentrated position as any position where more than 10% of your portfolio is tied up in one stock. No matter what you think about the long-term potential of your company, there are plenty of cautionary tales, such as Enron, where employees have substantial portions of their net worth evaporate overnight due to an overconcentrated position in their employer’s stock, which turns out to not be as solid as they believe. You’re not committing treason by selling a portion of your company’s stock, rather you are protecting your future through diversification.
Conclusion
Employee stock options can be a very valuable benefit of employment, but it’s important to know how they work. If you want to have a more detailed discussion on employee stock options or need advice on what type of options that you have, feel free to email me at daniel@sweetgrassfp.com or schedule a free introductory consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
