Understanding Employee Stock Options

As companies are looking to maximize the productivity of their workers, employee stock option plans are becoming a driving force in attracting and reattaining a quality workforce. This performance-based incentive is popular among private and public companies because it typically allows the employer to decrease their payroll in exchange for offering the employee a stake in the company. The strategy is often mutually beneficial for both employees and employers because it helps reduce turnover in key roles while motivating workers to perform well and potentially increase the value of their options.

Whether you are a new employee who has accepted a role where stock options are part of the compensation package or you currently hold equity in an option plan, understanding the nature of employee stock options is crucial to your financial health. In this blog, we will provide an overview of employee stock options, examine tax implications for cashing out options, and discuss how to make the most of your employee stock options.

The Basics: What are Employee Stock Options

Employee stock options are much like regular call options, and they are granted to employees as part of a compensation package. When issued, the options have a set strike price at which the employee may purchase shares of the company’s stock. However, unlike regular call options, an employee stock option plan will typically have a vesting period. Usually, the vesting period will be four years. The employee receives 25% of their total equity after one year of employment, known as the vesting cliff, and then slowly accumulates the rest for each year of employment.

Vesting schedules vary from company to company, and they may also be linked to performance incentives rather than specifically-defined time frames. Similar to regular options, stock options that are part of an employee compensation plan also have an expiration date. Due to the varying accumulation details, it is important to closely review the stipulations of your employee stock option plan, as well as whether you are being granted incentive stock options (ISO) or non-qualified stock options (NSO).

Incentive Stock Options

Incentive stock options, also called statutory or qualified stock options, are a form of equity compensation typically granted to top management and key employees. This type of stock option is taxed as capital gains rather than ordinary income, so it is generally quite tax-advantaged. When employees are granted ISOs, they do not need to report anything on their taxes until profits are realized. The tax advantages of ISOs come with a few stipulations that must be met to enjoy the benefits:

  • ISOs must be held for two years after the grant date
  • Shares must be held for one year after exercising

Non-qualified Stock Options

Non-qualified stock options are granted to general employees, so they are more common than ISOs. They are called non-qualified because they do not meet IRS requirements for special tax treatment. Because of this, NSOs will essentially be taxed twice. The first taxable event is when the NSO is granted, and this will be taxed as ordinary income. Once the NSO is exercised, a second taxable event is triggered wherein capital gains will be owed.

Tax Implications to Consider

The tax implications for employee stock options will differ depending on whether you receive ISOs or NSOs. If you are unsure what type of stock option you received, your employer will be able to tell you. Regardless of which type of stock option you have been granted, federal income tax will need to be withheld for any event that generates a profit. Typically, these events will include receiving the option, exercising the option, and/or selling the option. In the rare case where you receive an ISO that is not exercised within 10 years of being granted, the option will expire worthless, and no taxes will be due.

For all other situations, tax will be determined by subtracting the sale price from the strike price, which is the amount at which the options were granted to the employee. For example, suppose an employee receives 100 options as part of their compensation at a strike price of $10. If the market price of the stock is $50 at the time when the employee exercises the options, the taxable amount will be the market value minus the strike price. In this scenario, the employee would be responsible for paying capital gains tax on $4,000.

If the example above were for ISOs, the capital gains tax would be all that is owed; however, if the employee received NSOs, they would have also been responsible for paying ordinary income tax on the $1,000 value of the options when they were granted. As of 2023, ordinary income tax ranges from 10% to 37%, depending on the tax bracket. When compared to the 0%, 15%, or 20% capital gains tax rates, it is easy to see the benefits offered by the more tax-advantaged ISOs.

Making the Most of Your Employee Stock Options

Determining the correct time to exercise your employee stock options is a tricky task. Generally, you will only want to exercise the options if the market value of the stock is higher than the option’s strike price. Aside from the price, several other factors should be considered when determining the correct time to exercise the options. When deciding on whether or not it is time to exercise, be sure to ask yourself the following questions:

  • Do you anticipate moving into a higher tax bracket before exercising?
  • How much time is left until the options expire?
  • Have the options fully vested?
  • How many options were granted?
  • Do you have adequate funds to purchase the underlying shares?
  • What are your short and long-term financial needs?
  • What is your risk tolerance in waiting compared to exercising?
  • Once exercised, will you sell the shares or retain them?
  • How much of your wealth is tied up in the options?

Stock options as part of a compensation package may seem attractive, but it is important to consider how much of your wealth will be tied up in the options. There is a definite risk associated with holding a highly-concentrated position, and relying on company stock as a major aspect of your wealth strategy can become problematic if it is not properly managed by an investment advisor. Because of this risk, it is often a wise decision to divest funds from an employee stock option plan and allocate the funds for other investments. Determining the best path for you will depend greatly on your answers to the above questions.

While coming up with answers may not be easy, doing so will provide a clear picture of your strategy for exercising your employee stock options. If you are uncertain of the best path forward, meeting with a qualified financial advisor who has experience dealing with equity-based compensation can help remove stress and uncertainty. You have worked hard to be in a position that requires such deep consideration. To make the most of it, it is necessary to consider both short and long-term financial needs, and as always, act on insights rather than impulse.

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