Employee Stock Options: The Basics

The road to riches for many key employees and executives is paved with equity compensation. Today’s article is going to focus on Stock Options, the tool that started the equity compensation craze among tech companies (and subsequently all types of companies) to attract and retain talent and “share the wealth.”

The idea behind stock options is simple. Your company is letting you buy into the company at today’s value (or the value on the date your options were granted). The price per share is called the option’s strike or exercise price. This may not seem like a great perk at first since you have to “buy in” and the price you are paying is the fair market value of the shares at the time of the grant. However, you have several years (up to 10) to decide whether or not to exercise your options. Hopefully, the value of your company’s shares will go through the roof and then you can exercise your options, which are still at the “ground floor” price.

One Quick Thought

I want to share a bit of perspective before we go through the different types of stock options and key issues. Employees and executives often get excited about their stock options, even though it is almost impossible even to guestimate how much they will be worth. We have all heard stories of rank-and-file employees who became multimillionaires from their stock options. Unfortunately, that is the exception. Your options have zero intrinsic value on the day they are granted. Hopefully, the value grows, but most option grants end up adding a modest amount to total compensation, and some options end up being worthless. So, keep that in mind as you negotiate your compensation with a start-up that offers a lower salary than a larger, more established company.

Vesting

Typically, you must continue to work at the company for a specified period between when the options are granted and when you can exercise them. This time is called the vesting period. Often, the options vest in chunks (e.g., 25% per year for 4 years).


Two Types of Options

There are two main flavors of Stock Options: nonqualified stock options (NQSOs) and incentive stock options (ISOs). Some companies offer both. So, step one is to read your specific grant documents to be sure of the award type you are receiving. You can also ask the person at your company in charge of the plan if you have NQSOs or ISOs.

Nonqualified Stock Options (NQSOs)—Key Points

  • NQSOs are the most common form of stock option.
  • In addition to employees and officers, NQSOs can be granted to people who do not directly work at the company, such as outside directors, contractors, and consultants.
  • Unexercised NQSOs can be transferred to others just like any other asset. In other words, your options could be gifted or transferred as part of a divorce settlement.
  • There is no limit on the total number or value of NQSOs that can be granted. “Non-Qualified” means that your options do not qualify for more favorable tax treatment.
  • You pay taxes when you exercise your NQSOs on the difference between what you paid for the shares and their fair market value on the day of exercise. This is known as the spread. The spread is taxed just like other forms of compensation. The taxable amount is reported by your company on your W-2, as is the amount withheld by your employer for federal and state income taxes, Social Security taxes (up to the yearly limit), and Medicare.

Example: Your NQSOs have an exercise (strike) price of $10 per share.

  • You exercise them when the shares are valued at $15.
  • You have a $5 spread ($15 – $10) and thus $5 per share in ordinary income.
  • Suppose you exercise your options (buy the stock) and then hold the shares for a while. The stock has a good run and you sell your shares at $22 each. This means you would have a taxable capital gain of $7 per share ($22 –$15 cost basis). Whether the gain is long-term (lower tax rates) or short-term (ordinary income rates) depends on whether you held the shares for more than one year after exercise.

You need to report the stock sale on Form 8949 and Schedule D of your 1040 tax return.

Incentive Stock Options (ISOs)

Incentive stock options (ISOs) offer better tax treatment but are also more complex to navigate.

The spread between the fair market value and purchase price is not immediately taxable and not subject to Social Security, Medicare, or withholding taxes. The entire difference between what you pay for the stock and what you ultimately sell it for may be taxed as a long-term capital gain (lower rates than ordinary income). This sounds good, right? However, to qualify as ISOs, the options must meet several criteria:

  • ISOs can only be granted to employees. (Sorry directors, consultants, or contractors; you are not eligible to receive ISOs.)
  • There is a $100,000 limit on the aggregate grant value of ISOs that vest (become exercisable) in any calendar year. This is a bit confusing because the grant value is equal to (exercise price x the number of shares), regardless of the fair market value of those shares at the time you exercise your options. Any excess over $100,000 grant value becomes NQSOs for tax purposes.
  • ISOs must be exercised within three months after leaving a company. Your ISOs will lose their favorable tax treatment after three months and then be taxed like NQSOs. The three-month grace period is extended to 12 months if you are totally and permanently disabled.
  • ISOs cannot be transferred to others like NQSOs can.

ISO Holding-Period Rules

You must hold the acquired shares for at least two years from the date of grant and one year from the date of exercise, to receive the favorable long-term capital gains tax treatment. Meeting these holding-period requirements for ISOs can result in substantially lower taxes.

Example: Your exercise price is $10. You exercise your options when then fair market value is $15, and then hold your shares for a while before selling them at $22.

Holding period Sale price Taxable income
Less than 1 year from exercise* $22 $5 ordinary income (reported on W-2) + $7 short-term gain (same rate are ordinary income)
1+ year from exercise, 2+ years from grant $22 $12 long-term capital gain, no ordinary income

Alternative Minimum Tax (AMT)

Okay, here is where ISOs can get complicated…. The spread (difference between exercise price and fair market value) on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to alternative minimum tax (AMT) and additional tax-return reporting (e.g., Form 6251). This can be especially problematic if you pay AMT on “paper gains” but then your company’s stock price plummets, leaving you with a big tax bill on gains you never realized. The mechanics of how AMT works is beyond the scope of this article, but you can read all about it HERE.

Alert: If you have been granted ISOs, you must understand how the AMT can affect you. You should do an AMT calculation whenever you exercise ISOs and hold the shares.

Summary

The table below summarizes and compares selected major traits of NQSOs and ISOs.

Option type Eligible recipients Taxes are triggered upon… Taxes upon exercise Are taxes withheld? Taxes upon sale of shares
NQSOs Company employees, executives, directors, contractors, and consultants Exercise of options Ordinary income tax and payroll taxes on the spread Yes, income and payroll taxes Capital gains tax (short- or long-term)
ISOs Only company employees and executives Sale of shares, unless AMT is incurred in year of exercise Ordinary income tax, AMT, or none* No Capital gains tax*

*ISO taxation depends on: (1) when shares are sold; (2) the sale price relative to the exercise price and the fair market value at exercise.

Final Thought

In summary, stock options may be your winning lottery ticket or at least a meaningful part of your total compensation. Either way, you want to make sure you understand them and work with an advisor who can help you with the key decisions such as when to exercise them and how to plan for and (hopefully) minimize the taxes.

Email me if I can help.