Stock options are no longer just for the few executives at the very top of the org chart. Many publicly traded companies now make them available to non-executive staff. And while splitting compensation between cash and stock has some real benefits, turning those stock option certificates into real dollars takes some careful planning.
It is important to read carefully and understand the details of the stock option plans and their corresponding stock grant agreements. Be sure to remain aware of your choices, the term of your options, and the tax consequences of your exercise decisions. Although plans and grants from various companies may resemble each other in many ways, no standard stock option plan exists. Features of plans and grants may even vary within the same company. Plans also tend to include blackout periods and preclearance trading rules that apply to anyone in possession of material, nonpublic information.
It is also important to know what provisions exist in the event of termination, retirement, disability, or death. If expiration dates are not closely tracked, valuable options may expire unexercised. Many stock option plans offer participants 90 days or less to exercise vested options after job termination for retirement or disability. However, some plans stipulate that vested options are forfeited immediately if you leave the company to work for a direct competitor.
For most senior managers and executives, there are two basic types of stock options: the Non-Qualified Stock Option (NSO) and the Incentive Stock Option (ISO). The primary differences between NSOs and ISOs are the tax consequences at the time of exercise and sale.
An NSO is a type of employee stock option where its holder pays ordinary income tax on the difference between the price at grant and the price at which the option is exercised. NSOs are simpler and more common than ISOs. They are referred to as non-qualified stock options because they do not meet all of the requirements of the Internal Revenue Code to be qualified as ISOs.
An ISO is a company benefit that gives an employee the right to buy stock shares at a discounted price with the added appeal of a tax break on the profit. The profit on ISOs is taxed at the capital gains rate instead of the higher rate for ordinary income. ISOs are potentially quite valuable; however, they are bound by more rules, and are complex and riskier than NSOs. In fact, mistakes with ISOs can be quite costly. If held for at least two years from the date of grant and one year from the date of exercise, ISOs offer a more favorable long-term capital gains tax — rather than the ordinary income tax — on all appreciation over the exercise price.
For holders of stock options, it is important to have a plan for what to do at the time of grant, before exercise, and when the shares are sold. Stock options cannot be cashed in immediately; they must first meet their stated vesting requirements.
Historically, stocks increase in value over time. So, if the outlook for the underlying company is positive, you do not have to exercise the options immediately once they are granted. First, determine how you will handle the stock options over time. By doing this, you can enjoy the potential upside (e.g., increase in value) without having to expend any cash to purchase the stock.
A stock option plan has the potential to be an effective wealth-building tool, primarily due to the growth of the underlying company’s stock. Since the spread between the exercise price and the rising stock price grows without taxation, the continued buildup of equity may be used to help meet short- and long-term financial goals.
A traditional stock option gives its holder the right to buy stock up to 10 years into the future. Even so, option holders frequently succumb to the desire for instant gratification as soon as their options vest causing them to exercise and sell the shares. By all means, avoid this impulse. Some Certified Public Accountants (CPAs) and other tax experts will say that holding options for their full term is the best way to maximize their gains.
However, if stock options represent more than 25% of an investor’s net worth, diversification may be more important than waiting. It is also important to evaluate one’s own risk tolerance. If the company’s stock is volatile, resulting in the price swings being personally hard to tolerate, it may be better to exercise and sell stocks earlier.
Key Tax Considerations
It is generally advisable to stagger the exercises and subsequent sales over a period of years to spread out the tax bill. Every year, the brokerage firm responsible for administering a company’s stock option plan will issue its participants an IRS Form 1099-B. The form shows the exact dollar amount received from the sale of shares acquired through stock compensation. The receiver will use that amount, along with their cost basis, to calculate any gain or loss for tax purposes.
In general, any taxpayer who sells shares of a company during a calendar year must report the sale when filing that year’s taxes. There are, however, special issues that develop with shares that are acquired from stock options. Each type of stock compensation comes with its own form of tax treatment, so receivers of such grants should be sure to report stock sales accurately when filing taxes to avoid costly mistakes that attract the attention of the IRS.
For a person who holds unvested stock options, it may be attractive to make a Section 83(b) election on those shares. By making the election, you agree to pay taxes on the total fair market value of the unvested stock at the time it was granted rather than the sale date. In an environment where federal income tax rates are relatively low, the cost of selling is presumably less than it would be in future years if tax rates were to go up.
Making the 83(b) election also comes with some risks. Chief among them is that the strategy only works if the shares appreciate. Another risk is that making this election loses its worth and validity immediately if you leave the company before the shares have a chance to fully vest.