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Written by Thomas M. Geier, CPA, CFP ®, PFS

Do You Have Questions Regarding Employee Stock Options?An estimated 28 million workers participate in some form of equity ownership, according to the National Center for Employee Ownership. This number has risen dramatically over the years, as more companies recognize the need to incentivize and reward their employees. These rewards can be quite significant if the company performs well. However, these perks have risks in tow that warrant careful consideration and a solid understanding of all they entail. We can help guide you through this tricky labyrinth.

What Are Employee Stock Options?

At times, companies will give different types of stock options incentives to their employees by offering an option to buy company stocks at a discount. Employees are offered the right to buy a specific number of shares of employers’ stock at a specified price (also known as grant price, exercise price, or strike price), within a certain time period. Options have a vesting date and expiration date. An example of a vesting period would be a four-year vesting period with a one-year cliff. Basically, what this means is it will take four years before you have the right to exercise your options, but because your options vest gradually, you’ll be able to access some of your stock options before that four-year period is up. The one-year cliff represents the waiting period before any options vest. You can’t exercise them prior to the vesting date or after the expiration date.

Types of Employee Stock Options

There are two primary types. Incentive (statutory) stock options (ISO) and Non-qualified (non-statutory) stock options (NSO). We will take a brief look into both types and how they differ.

ISO

The biggest difference between the two types is tax-based. With an ISO, the employee does not pay tax at the time of exercising the option. They will have to pay the tax if the decision to sell the shares in the future is made. Once the sale is completed, capital gains tax is paid to the IRS, instead of ordinary tax. However, certain conditions must be met to qualify for an ISO and reap the tax benefits. The holding period is one year after the exercise and no less than two years after the grant date. There is also a limit to the total value that can become exercisable yearly, known as the $100,000 limit. Any amount in excess of this amount is treated as an NSO. Only certifiable employees (approved by a Board of Directors) of the company are eligible to exercise the option. The period of exercise is 10 years within the date of the grant.

Although exercising ISO’s is not a taxable event, the Alternative Minimum Tax (AMT) can be triggered. Any time an employee exercises the ISO’s and does not sell the shares by the end of the year, the difference between the exercise price and the stock’s current market price of the exercised stock will be hit with AMT. However, there is a silver lining. According to the Stock Options Counsel, the final Tax Cuts and Jobs Act of 2017 reduces Alternative Minimum Tax (AMT) bills for many who exercise Incentive Stock Options (ISOs) in two ways. “The increased AMT exemption decreases the likelihood of triggering AMT at exercise of ISOs. For those ISO exercises that do trigger AMT, the increased AMT phase-out threshold may reduce the amount of AMT due. Second, the bill reduced or repealed several triggers of the prior AMT, such as state and local tax deductions. This reduces the number of taxpayers who will need to use their AMT exemption amount for non-ISO AMT items.” As evidenced in 2018, most taxpayers did not use up the AMT exemption amount on non-ISO related items and therefore were able to use the entire AMT exemption amount to offset gains at exercise of options. In addition, the new thresholds may trigger the release of AMT credit carryovers.

NSO

An NSO is an offer to the employee from the company to buy shares of stocks at a price below its current market price. NSO’s do not qualify for the same tax advantages incentive stock options get. With NSO’s employees pay tax two times. First, ordinary income tax on the difference between the fair market value and the exercise price of the stock. This “spread” will be reported on your W-2. Second, when you sell the stock, you pay capital gains taxes based on how long you’ve held the stock. If held for one year or less, you’ll pay short-term capital gains (ordinary income tax rate). If held for more than one year, you’ll pay long-term capital gains (either 0 percent, 15 percent, or 20 percent, depending on your annual income).

An example of this would be:

You are awarded 200 stock options worth $60/share ($12,000 total) and you exercise the options when they each are worth $100 ($20,000 total). You would pay tax on the difference or $8,000 (your gain).

If an employee decides to leave their company, typically they have three months after termination to exercise their options, but in some instances, they may be required to exercise all vested options prior to their last day of employment.

Remember, exercising NSO’s triggers income taxes on the difference between the strike price and the fair market value. This can affect your marginal tax bracket.

You Have Choices with Stock Options

  • Convert and sellAn employee can purchase the discounted shares, convert the options into stock and sell all stocks after the required waiting period.
  • Sell and keep – Purchase the discounted shares and after the waiting period is over, sell some of the stock right away, but keep the remaining stock to sell at a later time, if and when the price rises.
  • Sell later – Purchase all options and convert them to stock. Hold on to the stock and monitor pricing with the plan to sell in the future, if and when the value of the share has increased.

How to Exercise Options

When exercising the option, it can be done via three different ways:

  • Cash – You buy the shares in cash (number of shares times the grant price) and you receive the number of shares, which you can keep or sell.
  • Cashless Option – A local brokerage firm handles the purchase of the stocks for the employee and sells the same stocks at the current market price on the same day. Upon completion, the loaned amount, commissions, and other charges are deducted, and along with the remaining balance, given back to the employee.
  • When determining when to exercise your options, you will need to consider your investment risk, tax planning, market volatility, your personal financial situation, and the future viability of the stock. If the current market value of the stock is less than the exercise price or even close to the exercise price, exercising the option may not be the best choice.
  • Stock Swap – The employee who already owns the shares of stock with the company, delivers it to the brokerage firm via a certificate to cover expenses related to the purchase of the options.

The primary point is that stock options are becoming a more common way for companies to incentivize and retain employees. However, options have risks and can certainly be confusing. Be aware of maintaining heavily concentrated stock positions in one company. If a negative event happens to the company, it could be detrimental to the individual with the concentrated risk. This supports the argument for diversification. The terms of your company’s options will be set through an employee stock option plan or contract you must sign. You should familiarize yourself with the terms/rules in that contract. Due to the many choices and rules inherent in stock options, it is extremely beneficial to meet with a financial advisor qualified in navigating the stock option labyrinth. Please don’t hesitate to contact us with any questions you may have.

Sources: The Balance/Forbes/Smart Asset/Market watch/Stock Options Counsel

© Geier Asset Management, Inc. Jan. 2019. Thomas M. Geier, CPA, CFP ®, PFA is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The articles & opinions expressed in this material were gathered from a variety of sources, but are reviewed by Geier Asset Management, Inc. prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of January 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual circumstances. In all cases, please contact your investment professional before making any investment choices. Geier Asset Management, Inc. is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.