Understanding Employee Stock Options

My company has granted me several stock options. What are stock options, and what do I need to know about them?

First, you need to know that stock options are a form of compensation so congratulations on earning additional rewards from your employer beyond your base salary. Stock options provide you with the right to purchase a company’s stock. Once you buy the stock, then you own it – just like any other stock that you purchase in your brokerage account. However, with options there are a number of key terms and considerations to familiarize yourself with:

Key Terminology to Understanding Stock Options

  • Stock option grant : Grants are akin to bonuses; companies offer grants to employees as an incentive to keep them within the organization. A single grant is a right to purchase a certain number of shares of company stock at a stated price within a specific period of time. Employees who remain with a company for a long time may have multiple stock option grants.
  • Vesting : In order to incentivize employees to remain with the company, stock option grants are often not yours for the taking immediately.  The company is investing in you, and therefore you must wait until your options are vested before you can exercise them. If you leave your organization before the options are vested, you forfeit them.
  • Stock option exercise : Once your options are vested, you can exercise your right to purchase.  Stock option exercise is the decision to purchase your granted shares of a particular stock option.
  • Strike price : As the name suggests, the strike price (also referred to as the exercise price) is the cost, per share, that you pay to buy the stock.
  • Spread or bargain element : Here is where the bonus comes into play: The strike price of your stock option is likely less than the market value of the stock on the date you exercise your option. Therefore, the spread, or bargain element, is the amount of money you earn on your purchase if you, in turn, sold your stocks.  

There are two popular types of employee stock options available: Non-qualified Stock Options (NQSO) and Incentive Stock Options (ISO).

Non-qualified Stock Options (NQSO) – NQSO, or NSO

Non-qualified Stock Options (NQSON or NSO), are pretty straightforward once you understand the key terms above. When these options vest, you have the right to exercise them, which means you purchase the stock at the given strike price. Once you own the stock, you must decide if you will keep it in your brokerage account with the belief that it will increase in value, or you may sell it and take the cash.  Non-qualified stock options are frequently preferred by employers because the company is allowed to take a tax deduction equal to the amount you are required to include in your incom

Tax Consequences of Exercising and Selling NQSOs

When you decide to exercise the NQSO, the bargain element is additional taxable income.  Put simply, the difference between what you paid and the full market value is treated the same as  a cash bonus.

Case in Point

Jack was granted 1,000 NQSO from his company on January 1, 2019, with a strike price of $20 per share.  One year later, in January 2020, 250 of those options vest.  On March 1, 2020, the shares are trading at $25 per share, so Jack decides to exercise his 250 stock options: he pays $5,000 (250x$20), and now owns 250 shares.  Since the share price is $25 each, his 250 shares are worth $6,250 or $1,250 more than he paid, which is the bargain element.  Jack has to report $1,250 in additional income in 2020.  Jack must now decide if he wants to hold onto the stock or sell it:

  • If he immediately sells the stock, Jack gets $6,250 (having paid $5,000). There is no tax consequence because the $1,250 is already reported as income.
  • Instead, Jack decides to hold the stock for 2 years and then sells all 250 shares for $40 per share, or $10,000.  Jack reports a long-term capital gain of $3,750: the difference between the $6,250 (the market value when he purchased the stock in 2020) and $10,000

Tax Consequences of Exercising and Selling ISOs

Incentive Stock Options (ISOs) provide more tax incentive to employees.  As such, they are more complicated and require the following:

  1. The option must be granted to an employee, meaning independent contractors and non-employee directors are not eligible.  An employee who leaves the company while holding active stock options must exercise them within three months.
  2. The grant period is ten years, so an ISO granted on September 15, 2019, must be exercised by September 15, 2029.
  3. The strike price must be equal to or higher than the fair market value of the underlying stock on the date of the grant.
  4. The employee cannot own more than 10 percent of the company at the time of the grant.
  5. The ISO grant is not transferable, with an exception in the case of death of the option holder.
  6. The value of all grants (strike price of shares) in a single year cannot exceed $100,000.

Tax Consequences of Exercising and Selling ISOs

It pays to know the difference between the types of sale of your stock.  Ideally, you want your bargain element to be taxed at the long-term capital gains rate (typically 15%) by performing a qualifying disposition versus a non-qualifying disposition. 

  1. A qualifying disposition occurs when you sell the stock at least:
    1. Two years after it was granted and
    2. One year after you exercise the option
  2. Otherwise, it’s a non-qualifying disposition and the bargain element is taxed at ordinary income rates which are generally much higher than the capital gains rate.

Another tax consideration is a potential increase in your AMT (Alternate Minimum Tax) calculation.  If you exercise your ISO’s (purchase the stock) but do not sell them in the same calendar year, the bargain element is included as income for calculating your AMT.  If your bargain element is high (excellent bonus for you), your AMT could be higher than the normal tax rate and you’ll owe more to Uncle Sam.  Fear not, you may receive an AMT credit in the future which will help balance the scales.

CASE IN POINT

Jane was granted 1,000 ISO from her company on January 1, 2019, with a strike price of $40 per share.  One year later, in January 2020, 250 of those options vest.  On March 1, 2020, the shares are trading at $50 per share, so Jane decides to exercise her 250 stock options: she pays $10,000 (250x$40), and now owns 250 shares.  Since the share price is $50 each, her 250 shares are worth $12,500 or $2,500 more than she paid, which is the bargain element.  Jane adds $2,500 as income for her AMT, but no tax consequences for her ordinary tax calculation.  After considering the numbers below, Jane decides to hold the stock.  Here’s why:

  • The stock goes to $65 per share 6 months later (Aug 1, 2020).  If Jane sells her 250 shares for $16,250, she makes a total of $6,250 of which she will report $2,500 as ordinary income and $2,750 as short-term capital gains. It would be a non-qualifying disposition.  She pays $2,000 in taxes: since she’s in the 32% tax bracket; (32% x 2,500) + (32% x $2,750) = $2,000
  • Instead, Jane decides to hold the stock for 2 more years and then sells all 250 shares for $65 per share, or $16,250.  Jane reports a long-term capital gain of $6,250 as a qualifying disposition.  She has a total tax bill of 15% x $6,250 = $937.50 – or $1,062.50 MORE in her pocket vs. the IRS.

When it comes to stock options, it pays to understand the details.