What are stock options?
A stock option gives you the right to purchase a stock at a predetermined price in the future. The number of options, exercise price, vesting date, and maturity of the options are all laid out in the company’s equity plan. A typical stock option grant will expire in 7-10 years if still employed by the company. Vesting (when the options are actually exercisable by the employee) usually occurs between 1-4 years.
Generally stock options are utilized by private companies that hope to go public in the future whereas public companies tend to issue restricted stock units and/or offer employee stock purchase plans for their equity compensation.
Stock options fall into two categories: Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). ISOs are highly regulated and must conform with a number of requirements under Section 422 of the Internal Revenue Code. In part because of their complexity, ISOs are less common than NSOs. However, ISOs are generally preferable to employees as they receive preferential tax treatment.
NSOs are any stock options that don’t qualify as an ISO (hence the Non-qualified name). Companies may prefer NSOs as they have fewer restrictions and allow the company to take a tax deduction when an employee exercises their options.
NSOs are taxed as ordinary income at the time they are exercised. The taxable income amount is the difference between the fair market value of the shares and the exercise amount. This tax is owed regardless of whether the shares are sold or held by the employee. If the employee holds onto the shares and then sells at a later date they will also have a taxable capital gain or loss depending on the performance of the stock.
ISOs are only taxed when the shares are sold and therefore there is no tax due when the options are exercised. As long as an employee keeps their shares for at least a full year after vesting and two years after their grant date then the employee’s gains qualify as capital gains as opposed to ordinary income. However the difference between the grant price and exercise price is considered part of your alternative minimum taxable income so that’s something to be aware of come tax time and in planning when you’ll exercise options.
It’s also worth keeping in mind that the default federal tax withholding on vested amounts valued under $1M is 22%. For some households that can create a potentially large tax liability if their marginal rate is significantly higher than that.
Maximizing the value of your stock options
The very idea of maximum value might mean different things to different people. Some may seek to maximize the after tax dollar amount of their stock options. Others may wish to minimize cash outlays for options, maximize their equity holding in their company, or fund some other investment or goal.
With stock options there’s no one size fits all answer to when to exercise your options and when to sell the stock. Each person and plan are unique and stock options introduce a lot more complexity and planning options than other equity compensation like restricted stock units.
In coming up with a plan for your options you will want to consider the value of your options, your tax situation, and your goals. For those owning NSOs, after exercising your option it’s generally best to sell your shares immediately if the company is publicly traded. There’s no additional tax impact to doing so and as I discussed when examining restricted stock units, most employees already have a lot of their future tied up into their employer’s fortunes. The recent drop in some former high flying stocks should help illustrate the risk one is taking in holding a concentrated position in their own company’s stock:
ISOs are a little more complex since there can be a significant tax benefit to holding onto shares after they’ve been exercised. Employees with ISOs may need to consider things like the valuation of their company’s stocks, their analysis of the company’s prospects, volatility of the company’s stock, how in the money their options may be, and whether the stock might qualify as Qualified Small Business Stock (QSBS).
In any case I think it’s important to develop a plan of attack to optimize your stock options for your unique financial situation. That gives you a base and makes it easier to make non-emotional decisions that help you achieve your financial goals. Then you can monitor the fortunes of your company and personal financial situation and adjust accordingly over time.
If you’d like help analyzing your situation please don’t hesitate to reach out,
Scott Caufield, CFA, CPA