Employee Stock Options

  by Tyler Curtis

by Tyler Curtis

Employee stock options have been a hot topic recently due to Facebook’s filing for an Initial Public Offering (IPO). Employees of Facebook reportedly own about 30% of Facebook from the stock options they have been issued over the years. Based on the most recent valuations 30% of Facebook is worth about $30 billion and analyst predict over 1,000 Facebook employees will become millionaires when Facebook goes public. Even if you weren’t lucky enough to get in on the ground floor of a multi-billion dollar company like Facebook there is still a good chance you have been granted stock options at some point in your career if you have worked for a publicly traded company. We often have clients ask us what they should do with the stock options they have been granted and how the process of exercising them works.

An employee stock option is a call option on their employers stock, which is issued as a form of non-cash compensation. It gives an employee the right to purchase a certain number of shares of the company’s stock at a pre-set “strike” price over a certain period of time “exercise period”. In most cases the strike price is equal to the market value of the stock at the time the option is granted; however, it can be lower or higher depending on the type of option. Employees profit if they are able to sell their stock for more than what they pay at exercise. It is not unusual for employee stock options to have an exercise period of up to 10 years from the date of issue, while standardized options usually have a maximum maturity around 30 months. Any restrictions within the exercise period are prescribed by a “vesting” schedule, which sets the minimum amount of time that must be met before the options can be exercised.

Companies have the option of issuing different types of options depending on what they are trying to get out of the offering. These various types of options have different tax implications to both the company issuing them and the employee receiving them. In general most offerings fall in one of two categories: non-qualified options or incentive stock options “ISO’s”.

Non-qualified stock options

Most broad-based stock option plans issue non-qualified stock options. Companies typically prefer this type of option because they are allowed to take a tax deduction equal to the amount the recipient is required to include in his or her income. Generally, the employee will owe no taxes when the options are granted, but required to pay ordinary income tax on the spread between the strike price and market value when the options are exercised.

Choosing the right time to exercise employee stock options and deciding what to do with the resulting shares can be challenging. For example if you decided to exercise an option to buy 1,000 shares at $10 and the stock was trading at $20 in the public market your would net you a total gain of $10,000. The full $10,000 gain would then have to be claimed as ordinary income.

You now hold 1,000 shares of your company’s stock. Let’s say you think the stock is going to trade higher, so you hold onto your shares. Instead of going higher the stock crashes and trades down to $10 and you decide to sell all 1,000 shares. In this scenario you still owe income tax on the original $10,000 gain, even though you never received it as cash. The IRS sees the gain as income that you decided to invest in the stock you kept. You will be able to take a capital loss of $10,000 from the shares you sold at $10 which will help to offset your gain, but not entirely.

If you decided to hold onto the shares and the stock appreciated in price any subsequent gains would be taxed at the capital gains rate when you sell. If you hold onto the stock for more than one year any gains would then be taxed at the long-term capital gain rate.

Incentive stock options

ISOs are also sometimes referred to as qualified stock options, they are “qualified” because no income tax is paid at the time the options are granted or when they are exercised. Instead, if the shares are held for one year from the date of exercise and two years from the grant date then profits made on the sale of shares is taxed at the long-term capital gain rate. Although ISOs allow the holder to receive favorable tax treatment, they also require the holder to take on more risk by having to hold the stock for a longer period of time to receive optimal tax treatment. ISOs are typically reserved as perks for upper level management, who tend to benefit more from the capital gains tax treatment.

When to exercise?

The big question when discussing employee stock options is when to exercise. The decision to exercise your options depends on several factors as well as your particular situation. Conventional wisdom may tell you to hold onto the options until they are close to expiration in order to maximize your gain and delay paying taxes; however there are several legitimate reasons to exercise early.

The strongest argument for exercising early is if you have accumulated a large position in your company’s stock over the years. Exercising your options early will allow you to diversify your portfolio by investing the funds elsewhere. It is generally not advised to hold a large portion of your portfolio in your employers stock because your future income and employment prospects are closely tied to the performance of your company’s stock. You may also consider exercising early to avoid being pushed into a higher tax bracket. Exercising a portion at a time can help alleviate the problem.

Another argument for exercising your options early is to lock in a lower cost basis and allow for gains in the future to be taxed at the more favorable capital gains rate, assuming the stock appreciates in the long term. It is important to recognize that this practice is the same as making an investment in the stock. Any time you purchase stock, regardless of the method used it carries the same potential risk of decline.

Deciding when to exercise your employee stock options can have a major impact on your overall portfolio and tax liabilities. When making decisions of this magnitude it is always best to first consult your financial advisor and seek the advice of a tax professional.

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