Brief Overview of Employee Stock Options

You may have employee stock options as part of your compensation package. Employee stock options can be confusing and you may be wondering what you should do with yours.

This is Part I in a series shedding light on employee stock options, their taxation, and strategies for managing them. 

Non-Qualified Employee Stock Options vs. Incentive Stock Options (aka Qualified Employee Stock Options)

There are two basic types of employee stock options; nonqualified stock options and incentive stock options. Both types allow you to purchase employer stock at an exercise price and sell at a higher market price.

For example, employee stock options for 100 shares of company stock grants you the right to buy 100 shares at an exercise price. Should the market price rise far enough above the exercise price, you will be left with a nice profit. 

So if your options specify an “exercise” price or “strike” price of $10/share and the stock currently trades at $100/share, you can buy shares for $10 and hold them or sell for $100/share.

Vesting and Expiration of Employee Stock Options

Both of these options have a vesting period in which you become eligible to exercise the options. They also have an expiration date after which you can no longer exercise your stock options. 

The most popular incentive stock option vesting schedule is 4 year vesting with a 1 year “cliff”. This means that each month, you will become vested in 1/48th of the shares (because there are 48 months in 4 years). 

The “cliff” refers to the stipulation that you must be employed for a full year before you can exercise any vested shares. 

Nonqualified stock options have vesting periods that typically range from 3 to 5 years.  

As long as you are employed with the company you usually have 10 years from the beginning of your vesting period before your options expire. After expiration, you will no longer be able to exercise your options. 

If you are no longer employed, you should refer to your plan document to see about the stipulations regarding your employee stock options.

If you left your employer before your options were vested, you will likely lose them however you will generally have a chance to exercise vest options if you act quickly enough.

You Will Likely Owe Taxes on Employee Stock Options

Simply being granted nonqualified stock options or incentive stock options is not a taxable event. Exercising your options on the other hand can be a taxable event.

Before you can understand how your exercised options will be taxed, you must understand the “bargain element”. 

Bargain Element of Employee Stock Options

The market price of the company’s stock minus the exercise price of the options is called the bargain element. 

The exercise price of the options are set when the company grants the options. The options will only have value if the current market price for the company stock is greater than the exercise price of the options. 

This price difference is the bargain element. It is the amount you are taxed on when you exercise your options.

Example:

You have nonqualified stock options to purchase 100 shares at $10/share, you exercise those options when the share trades for $100/share. ($100-$10) x 100 shares = $9,000, your bargain element and the amount on which you will owe any taxes. 

Exercising Employee Stock Options Takes Cash

Since you are buying shares at the exercise price and paying taxes on the gain (bargain element), you need cash. 

If you don’t have the cash on hand, you will need to do a “cashless exercise” (aka sell to cover)

In a cashless exercise, a lender (usually a large bank/broker) provides cash to purchase the shares at the exercise price. The lender then sells them at the market price and returns the proceeds (minus a fee) to the employee.

If you exercise your options but hold the company shares, the bank/broker will forward the shares remaining after selling enough to cover the cost (hence “sell to cover”) of the shares and taxes. 

Example of cashless exercise and immediate sell:

You have nonqualified stock options to purchase 100 shares at $10/share. The stock currently trades at $100/share.

Since you do not have the cash on hand to pay $1000 to purchase the share or pay the resulting taxes on the $9000 of income, you choose to do a cashless exercise. 

The bank/broker purchases the shares for $10/share using its own money, and sells the shares in the market at $100/share. 

The bank/broker then withholds the taxes and takes a small fee for facilitating the transaction. 

The resulting proceeds are then forwarded to your account as cash.

Example of a cashless exercise with limited selling to cover fees and taxes:

Using the same assumptions as above, the bank/broker does not sell all of your shares in the market for $100/share or $10,000 total.

 Instead the bank/broker only sells 10 shares to cover the initial $1,000 to purchase the stock, and a few more shares to cover the taxes from the transaction.

Taxation

How you are taxed on your stock options depends on the type of stock options you have. 

In either case, you will never owe taxes simply because you were granted or became vested in incentive stock options or nonqualified stock options. You will only owe taxes if you elect to (83(b) election) or if you exercise your options.

Nonqualified Stock Options Taxation

Exercised nonqualified stock options are treated as W-2 income (including Medicare and Social Security taxes). You will pay income taxes, and Medicare and Social Security taxes on the bargain element (market price minus exercise price x number of shares).

After exercising the options you will have the option to sell the company stock (if you didn’t do a cashless exercise and immediate sell) to use any proceeds from the transaction. Any subsequent gains or losses on the stock after you’ve exercised the options and paid income taxes are treated as long (held of >12 months) or short (held for < 12 months) capital gains or losses. 

Nonqualified Stock Option Taxation Example:

You are granted nonqualified stock options for 100 shares with an exercise price of $10/share. After 5 years, you exercise and immediately sell the options when the company stock price is at $100/share. You will have w-2 income of ($100-$10)x100 shares = $9000.00. 

Incentive Stock Options Taxation

Incentive stock options are different. When you exercise an incentive stock option you will not owe any w-2 or social security/Medicare taxes immediately. You will however have an Alternative Minimum Tax (AMT) “adjustment”. 

The AMT is based on a parallel tax system called the “Tentative Minimum Tax”. If the taxes you owe under the Tentative Minimum tax system are higher than the taxes you would owe under the ordinary tax system, then you have to pay the higher of the two.

AMT consequences become more likely if you have a very large gain in your incentive stock option shares relative to your income. (For a more in depth discussion on AMT implications read Part 2 of this blog series.) Ideally, AMT won’t impact you when you exercise your incentive stock options.

The typical goal when exercising an incentive stock option is to make the exercise and sale of stock a qualifying disposition. Assuming you have no AMT considerations, then a qualifying disposition is a good goal to have. 

Under a qualifying disposition, any gain in the exercised incentive stock options will be treated as a long term capital gain; a preferential standard when compared with ordinary income (like nonqualified stock options) or AMT.

For the sale of company stock to be a qualifying disposition, the stock must be held for at least 1 year after exercising the options, and 2 years after the options were granted. 

Failing to meet these requirements will result in a disqualifying disposition. A disqualifying disposition means that any gain on exercised incentive stock options are treated as ordinary income (minus Medicare/Social Security taxes). 

If your incentive stock options will create AMT taxes for you, then a disqualifying position is one way to avoid such taxes. If AMT is not a consideration, and you don’t need the cash, take advantage of the capital gains tax treatment of qualifying dispositions.

Incentive Stock Option Taxation Example: 

You are granted incentive stock options for 100 shares with an exercise price of $25/share on 01/01/2015. After 5 years on 01/01/2020, you exercise the options when the company stock price is at $50/share. 

There are no tax consequences until you sell the shares from the exercised options. You sell the shares on 01/02/2021 for $55/share. Since you met both rules for a qualifying disposition (shares sold at least 2 years after the date of grant and 1 year after the date of exercise) You will only owe long term capital gains on (55-25)*100 = $3000.00

 None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation. 

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