What are Employee Stock Options?
Employee stock options give a firm’s employees the right to purchase its shares at a pre-determined price and within a specific time period. They are part of compensation plans and used to retain employees and senior executives. There are two types of stocks: non-qualified stock options and incentive stock options. The former type of stock options is taxed at regular income tax rates and the latter type may provide tax benefits to users. Some companies offer a combination of both types to employees. Strategies to exercise stock options vary and depend on the employee’s priorities.
Basics of Stock Options
Employee stock options are often confused with Employee Stock Owner Plans (ESOP). They are different from each other. Stock options give you the right to own company stock at a future date and at a predetermined price. ESOPs provide ownership of company stock held in a trust. The employee gets access to the stock after he or she has fulfilled certain job-related conditions, such as performance-related goals or staying with the company for a set duration.
Employee stock options are popular with startups that aspire to a public listing. They are part of compensation plans at such companies and are used to retain employees and offset differences in salary from more established firms. Stock option agreements can be complicated affairs, full of jargon and figures. Here is a brief rundown of important terms that you will likely encounter in such agreements.
- Grant Date: This is the date on which the stock options are granted to the employee. The grant date is not the date at which you can exercise the options.
- Strike price or exercise price: This is the price at which the options become available to the employee. For example, a strike price of $10 means that you can purchase company stock at a price of $10 in public markets, irrespective of the actual price at which it is trading when you exercise the options.
- Vesting schedule: Vesting relates to the ownership of options. You can gain ownership over a period of time or immediately. For example, 10,000 stock options with a vesting schedule of 2 years are generally disbursed in tranches of 5,000 options each year.
- Exercise window: This is the time period over which you can buy the options. It is a fixed period.
- Expiration date: All stock options agreements come with an expiration date. This is the date when your right to exercise the options expires.
Based on their tax treatment, stock options can be divided into two types.
Non-qualified stock options are the more popular type of stock options for employees. The sale of non-qualified stock options is treated as regular income by the IRS and taxed accordingly. Therefore, when the options are exercised, the employer withholds federal, state, and local taxes, thereby reducing the number of shares that might be available to you.
Tax is also applied to the spread or difference between the strike price and market price. This is spread is known as the discount of bargain element. Therefore, if the options are exercised and stock is purchased and sold within a period of one year, then the IRS treats it as regular income and taxes it as such. However, if the purchased stock is sold after more than a year, then long-term capitals gains apply.
Incentive stock options receive special tax treatment from the IRS. Taxes are not withheld when they are exercised. They also qualify for long-term capital gains treatment if they are held for more than one year from the date of exercise or two years from the date that they are granted. However, gains accruing from the options must be added back to tax calculations for Alternative Minimum Tax (AMT). The $100k rule can also incur tax. According to this rule, incentive stock options above $100k are taxed as ordinary income.
Things to Consider While Exercising Stock Options
The process to exercise options is fairly similar to the one for purchasing a stock. You should contact your broker (or other relevant company official) and instruct them to carry out the transaction. The number of shares that may be available to you will differ from the promised number, if they are non-qualified stock options.
The timing and sale of exercise options depends on individual circumstances and priorities.
Consider your overall finances and goals for the future, when taking a decision to exercise stock options. As mentioned earlier, timeframes for of options play a key role. For early employees at a startup, a public offering of the company’s shares is an excellent time to cash in on the options. Those who came in later might have to wait before they can cash in.
Options-based compensation is an important part of the salary for senior management at startups and established companies. However, it may not be a good idea to exercise your options all at once for two reasons. First, it may end up creating a massive tax liability for you that will dramatically reduce your profits from the sale. Second, it sends out a negative image to investors in the company and may prove detrimental to its stock price in the long run.