Whether you're working at a pre-IPO start-up or a large publicly traded company that provides world-changing technology, employee stock options can boost your current and long-term wealth. Stock options are relatively straightforward, but the devil is in the details, just like everything else. Maximizing your profit is the goal which means taxes are an essential variable in the profit maximization equation. And the rules are complex.
Employee Stock Option Basics
The company does not pass you shares of stock immediately when you obtain stock options. An option provides you the right to purchase shares of company stock at a specific price during a certain period. The option allows you to buy the stock below market value in most situations. Ideally, the shares' price will rise over time, enabling you to sell them at a higher price than when you exercise the options. Here are some key terms:
Exercise price - The price at which you purchase the shares of stock. The stock option comes with a defined exercise price.
Market price - The price at which the company trades on the open market. The market price is the price you can find during trading hours on the ticker on many business news sites or TV channels.
Bargain element - The difference between the exercise price and market price. It's the difference between what you paid and what you would have paid if you purchased the shares on the open market.
In-the-Money - This is when the exercise price is less than the market price. In-the-money means you have a potential profit as the option owner if you exercise.
Underwater or Out-of-the-Money - This is when the exercise price is greater than the market price. The option is worthless when it is underwater. Why would you pay the exercise price if you could purchase the stock cheaper on the open market?
Dates to Keep in Mind
These dates can have significant tax implications.
The grant date is the date you receive the options from your employer.
The vesting date is the date you can exercise the options. Vesting is a defined period, but it can also be contingent on performance.
The expiration date is the final day you may have the ability to buy the shares at the exercise price.
Exercising Your Options
When you exercise your stock options, you may purchase shares of your employer's common stock at a price indicated in your option grant. The spread, also called the bargain element, is the difference between the exercise price and the shares' market price when exercising your options. But it is called an option for a reason. You do not have to exercise as the owner of an option. Below is a hypothetical illustration of a stock option payout schedule.
The stock must vest before you can exercise the options or purchase the shares. Vesting means you have to be employed for a specified period or reach a particular milestone to obtain those shares. In some situations, you may be able to exercise your options early, i.e., before they vest. Early exercise can have tax advantages, but there are downsides as well. Your company may prohibit you from selling your stock shares to purchase the vested shares, so you'll use your cash.
The Types of Options
Employer-provided stock options come in two flavors. They can be the more common non-qualified stock options (NQSOs) or incentive stock options (ISOs). ISOs provide tax benefits and can trigger alternative minimum tax (AMT) issues (which can result in an overall less tax efficient outcome if not managed correctly). ISOs enable employees to convert part or all the potential stock earnings into capital gains if they hold on to the stock for a certain period. Capital gains receive a more favorable tax schedule than the income tax brackets.
Key Options Questions
How do I exercise stock options?
Exercising stock options means purchasing shares of your employer's common stock at a price defined in your option grant. Your company may contract with a brokerage company to conduct these stock purchases. You do not have to sell the shares immediately once you own them. You also do not have to exercise your options.
What is the timeline?
If your company does not offer early exercise, you can only exercise options once they are vested. Vesting schedules vary from company to company.
What should I consider when deciding whether to exercise?
What is the purpose of the exercise? Your goals will dictate when you exercise and sell the stock. You may wish to accumulate a position in your employer's stock because you believe it is a superior investment. Or you may have a holding requirement as a director. These objectives require one set of decisions. A different set of actions is necessary to maximize current potential profits.
Can I exercise my options? Review your vested options. You can't exercise unvested options. Furthermore, check if your company allows for early exercise for those unvested options.
Is it profitable to exercise? Are the options in-the-money or underwater? If they are underwater (trading below your exercise price), it would be prudent to wait for the stock price to rise before exercising. If they are in-the-money, it may be appropriate to exercise (shares are trading above the exercise price).
Is your company publicly traded? If your company is private and does not have plans for filing an IPO, exercising your options may be risky because you are purchasing shares that may not become liquid. In other words, you won't have a market to sell your shares. It is hard to sell something with no buyers, and ultimately your shares could become worthless.
Are you confident in the direction your company is heading? Remember, you are buying shares in your company. If you plan to hold the stock beyond exercise, you should be confident in your investment decision. Your company's successes and failures impact its stock price and your gains or losses.
How will you finance the purchase if you exercise? If your company has not launched an IPO, you will have to use your cash to exercise. Alternatively, if your company is already publicly traded, you may be able to use a cashless exercise. Cashless exercise allows you to purchase shares without using any of your cash. Delaying the purchase can also be a tactic. Your strategy will depend on your situation, whether your company is publicly traded, and what your option plan offers.
What taxes will you owe? Depending on your circumstances (what kind of options you have, the number granted, your total income, etc.), you may owe taxes when you exercise.
Should I sell my shares?
After exercising your options, you may want to consult with a financial planner to discuss the most advantageous and profitable manner to manage the stocks. After exercising your options, the type of options you own and your holding period will significantly impact your tax liability. And, now that you hold the stock, you are exposed to company-specific performance risk. You can still lose or gain money in your position. It is not until you've sold the shares that you have realized a gain or loss. You generally face three options when selling your shares:
Exercise and sell shares immediately
Exercise and sell shares within a year
Hold on to shares for longer than a year (and potentially longer to attain qualifying ISO status)
You also need to consider if you can sell. If your company is pre-IPO, lock-up periods require careful planning. And if you work at a publicly traded company, you want to adhere to any trading window to avoid insider trading issues.
Are you looking for a checklist to help you manage your stock options? Download your employee stock options checklist.
NQSOs - Non-Qualified Stock Options
NQSOs are a common type of stock option. Most companies typically provide non-qualified stock options to employees for tax reasons. With NQSOs, the company can deduct the costs of the options as an operating expense sooner than with other options.
NQSOs have features ISOs don't have. You can pass nonexercised NQSOs to others. And the IRS does not restrict the quantity or value of NQSOs that a company can grant to an employee.
If you make money when you exercise your shares (i.e., your exercise price is lower than the current market price, in-the-money), this is considered ordinary income. The bargain element is subject to ordinary income, Social Security, and Medicare taxes. Your company reports your NQSO income on your IRS form W2 for the year you exercised the options.
Once you receive the shares, you can either sell them or hold on to them. At this point, they will be subject to capital gains tax.
ISOs - Incentive Stock Options
There is a $100,000 limit on the total value of ISOs that you can vest and exercise within a calendar year to maintain their tax preference. Furthermore, you cannot transfer them to other people like the NQSOs. Taxation can be more advantageous for ISOs if you adhere to a well-crafted plan.
A qualifying disposition of ISOs results in only capital gains tax (no higher ordinary income tax). To qualify for long-term capital gains, you'll need to hold onto the shares for two years from the grant date and one year from the exercise date.
You should examine Alternative minimum tax (AMT) before exercising ISOs. AMT increases your total tax due. Being subject to AMT can erode the tax preference offered by ISOs. The AMT is adjusted based on the bargain element. The bargain element is the difference between the price you pay for the shares (the exercise price) and the fair market value when you exercise. There is some flexibility in avoiding or minimizing AMT because you may decide when to exercise your options. Deciding on when to exercise requires careful planning of your income. A financial planner can help you model various scenarios to select the right course of action for your situation.
Managing Concentrated Wealth
Employee stock options provide an avenue to grow your wealth. However, having too much of one thing can be risky too. You should manage your portfolio's risk profile. You should align your portfolio with how much risk you can take, tolerate, and need. And accumulating too much of your employer's stock can increase risks to your portfolio and financial plan.
Keeping employer equity risk in mind is essential. In addition to stock options, you may also receive stock via an employer stock purchase plan (ESPP) or restricted stock units (RSUs). As a participant in all these programs, you may own a substantial percentage of company stock relative to your entire portfolio. For this reason, you should carefully consider the benefits of holding the equity for extended periods versus the benefits of diversifying your portfolio. So here are the key things you should consider:
How much employer stock are you willing to hold as a percent of your total portfolio?
How will you manage concentration risk if you plan to have a large amount of company stock in your portfolio?
Are you required to hold a certain amount of employer stock?
What objectives will you be working toward when owning so much employer stock?
With a concentrated position, your income and your portfolio's performance can begin to rely heavily on one source, your employer.
The Bottom Line
Stock options can be a powerful tool in building wealth. But as you can see, employee stock options are complex. Working with a trusted financial advisor can reduce your stress and help you map out the best course of action for your situation. Are you trying to figure out what to do with your ISOs and NQSOs? At Pursuit Planning and Investments, LLC, I help you think through your options. I ultimately help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your goals and begin best optimizing your financial plan in that meeting.
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