employee stock options Archives - Albion Financial Group

Executive Summary:

Employee stock options allow employees to purchase company stock at a fixed price, offering potential gains if the stock price goes up.
There are two main types of stock options: Incentive Stock Options (ISOs) with favorable tax treatment and Non-Qualified Stock Options (NQSOs) with more flexibility but less favorable tax treatment.
Key considerations for managing stock options include understanding the vesting schedule, timing of exercise, tax implications, concentration risk, market conditions, and aligning with your financial goals.
Lastly, consulting with trusted advisors is critical to making informed decisions and maximizing the benefits of your stock options.

Employee stock options are a powerful tool used by many companies to attract, retain, and motivate employees.

At a high level, they provide employees with the opportunity to purchase company stock at a fixed price, potentially leading to big gains if the stock price goes up. Many well-known companies, like Apple, Google, Microsoft, Amazon, and Tesla, use stock options, including both Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs), to align employee interests with company performance.

But, it’s not just large publicly traded companies that offer stock options. Many startups and small businesses use stock options as an attractive alternative to high salaries to conserve cash and reward early employees.

If you have stock options, understanding how they work and how to manage them effectively can help you make smart decisions and maximize the benefits they can provide.

First, What are Employee Stock Options?

Employee stock options are contracts that grant employees the right to buy a specific number of shares of the company’s stock at a predetermined price, known as the exercise or strike price, after a certain period known as the vesting period. These options typically have an expiration date, by which time they must be exercised or they will expire. Stock options provide employees with the potential to become shareholders in the company and benefit from its success.

Stock Option Example:

As an example, a typical stock option might give an employee the right to purchase 1,000 shares of the company’s stock at a strike price of $50 per share. If the stock price rises above $50, the employee can exercise their options and buy 1,000 shares at that lower price, effectively making a profit. Then, employees can decide whether to hold onto the stock or sell it for a profit.

Alternatively, if the stock price drops below $50, the employee can simply choose to wait, either until the price goes up beyond the strike price, or until the options expire, avoiding any potential loss.

Two Main Types of Employee Stock Options

When it comes to stock options, there are two main types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs).

What are Incentive Stock Options (ISOs)?

Incentive stock options are company stock options granted to employees that may provide tax benefits if certain conditions are met.

Tax Advantages: ISOs offer favorable tax treatment if certain conditions are met. When employees exercise ISOs, they do not have to pay regular income tax on the difference between the exercise price and the fair market value of the stock. Instead, this difference, known as the “bargain element,” is subject to Alternative Minimum Tax (AMT). Then, if the shares are held for at least one year after exercise and two years after the grant date, any gain on the sale of the shares is taxed at the more favorable long-term capital gains rate.

Eligibility: ISOs can only be granted to employees (not to directors, contractors, or consultants).

Ultimately, ISOs can be a valuable tool for both employers and employees. They can serve as a way to incentivize and reward top-performing employees, while also providing tax benefits for both parties. But, because there’s a layer of complexity involved in receiving favorable tax treatment, it’s essential to consult with a trusted advisor before executing your options.

What are Non-Qualified Stock Options (NQSOs)?

Non-qualified stock options are a type of employee stock option that allows employees to purchase company stock at a fixed price, with fewer restrictions and no special tax benefits compared to incentive stock options.

Tax Treatment: NQSOs do not qualify for special tax treatments. When employees exercise NQSOs, the difference between the exercise price and the fair market value of the stock is taxed as ordinary income at their highest marginal rate. This amount is also subject to payroll taxes. Then, any subsequent gain or loss upon selling the stock is treated as capital gain or loss.

Flexibility: NQSOs can be granted to employees, directors, contractors, and others, providing greater flexibility for the company.

Ultimately, NQSOs can be a valuable tool for companies looking to attract and retain top talent, even without the same tax benefits as ISOs. By offering employees the opportunity to purchase company stock at a discounted price, NQSOs can act as a powerful incentive for them to perform well and contribute to the company’s success.

Key Considerations for Managing Stock Options

When it comes to your stock options, planning is key. Here are some important considerations to keep in mind when managing your stock options:

Vesting Schedule: Understand the vesting schedule of your options. Vesting determines when you can exercise your options and purchase the shares. Options typically vest over a period of time, such as four years, with a portion of the options vesting each year.

Exercise Timing: Deciding when to exercise your options can have significant implications. For example, when exercising ISOs, many try to avoid exercising during a year with high income to minimize the alternative minimum tax (AMT) implications. In addition, there are certain rules to consider, such as not exercising more than $100,000 in ISOs in a given year AND the 10-year time limit to exercise your options from the grant date.

Tax Implications: Consult a tax advisor to understand the tax consequences of exercising and selling stock options. The timing of your exercise and sale, as well as the type of option (ISO or NQSO), can significantly impact your tax liability.

Concentration Risk: While stock options can provide substantial financial rewards, they also carry risk. Relying too heavily on company stock (when you already rely on them for a paycheck) can expose you to significant financial risk if the company’s stock price falls or the business falters. Diversifying your investment portfolio is crucial to managing this risk.

Market Conditions: Consider the current market conditions and the performance of your company when deciding to exercise and sell your options. While no one knows what the future holds, it’s wise to weigh everything you know about the company with what you know about the current state of the market as market volatility can affect the value of your stock options.

Financial Goals: Align your stock option strategy with your overall financial goals. Whether you plan to use the proceeds for retirement, buying a home, or other financial objectives, having a clear plan can guide your decisions.

These are just a few of the key considerations to keep in mind when it comes to managing your stock options. As always, it is important to consult with a trusted professional for personalized advice based on your unique situation.

Remember that stock options can be a valuable asset but also come with potential risks and complexities. By understanding the basics and carefully considering your options, you can make informed decisions that align with your financial goals.

Conclusion

In the end, employee stock options can be a valuable component of your compensation that can lead to significant gains if managed wisely. Understanding the different types of options, their tax implications, and the strategies for exercising and selling them is essential. By considering these factors and consulting with trusted advisors, you can make informed decisions that align with your unique goals and risk tolerance.

Albion Financial Group is an SEC registered investment advisor. The information provided is intended solely for educational purposes and should not be construed as an offer or solicitation for the purchase or sale of any particular securities product, service, or investment strategy. Past performance is not indicative of future performance. Additional information about Albion Financial Group is also available on the SEC’s website at www.adviserinfo.sec.gov under CRD number 105957. Albion Financial Group only transacts business in states where it is properly registered, notice filed or excluded or exempted from registration or notice filing requirements.

You’ve worked hard for your employer for several years and been rewarded with options on the company stock. Now stock options make up a large share of your wealth and you’re thinking it’s time to pay more attention. But what are these options worth and how should they be handled? As employers have grown more creative with compensation, questions like these no longer apply only to the executive suite. In many companies options are now available to employees of all levels and for some represent a substantial portion of their total compensation package. Understanding how stock options work, and determining how to maximize their value can be complicated. While employee stock options can be great wealth creation vehicles, understanding what they are and how they work will greatly increase the odds of a positive outcome.

Stock options grant the holder the right to purchase shares in a company at a specified price (exercise price) for a specified period of time (expiration). The aim of granting options is to incentivize employees; aligning their interest with that of the company. By doing so the company hopes to increase operational performance and thus profitability. There are two types of options awarded; incentive stock options (ISOs) and nonqualified stock options (NQSOs). The key difference between the two is how they are treated for tax purposes.

Incentive Stock Options (ISOs)
ISOs offer more favorable tax treatment than NQSO’s, taxing the gain on the sale of the underlying shares at long-term capital gains rates if the holding rules are correctly followed. There are two important holding periods to meet the holding rule requirement. The first holding period begins with the grant date of the option. The option holder must wait at least two years from the grant date prior to selling the underlying shares in order to have the gain taxed at long-term capital gains rates. The second period begins when the stock is transferred to the employee. In order to receive long-term capital gains treatment the shares must be held for at least one year following the date the stock was transferred. If the two holding periods are met then the gain will be considered long-term. Be aware that ISO’s are an alternative minimum tax (AMT) preference item and in certain circumstances can trigger AMT.

Nonqualified Stock Options (NQSOs)
NQSOs are less tax favorable, but are more commonly used as they are not subject to the same restrictions on issuance as ISO’s. When a NQSO is exercised tax is due at ordinary income rates on the difference between the exercise price and the value of the stock at the time of exercise. The exercise price becomes the cost basis for the position going forward. When the shares are eventually sold they will be subject to short-term or long-term capital gains based on the length of the holding period from the time of exercise.

Option Risks
Stock options are a great way to build wealth and over time may come to represent a large share of one’s net worth. However there are risks. First and foremost is concentration. Not only does the employee rely on the company for income but he also depends on the ongoing success of the company if his net worth is to be maintained. A failure of the company is a double whammy; the income is gone and the stock option assets on his personal balance sheet have greatly diminished in value. It is important to sensibly diversify the balance sheet from time to time to avoid having all eggs in one basket.

Exercising Options
The method used to exercise options can also have unintended consequences. In the late 1990’s many technology and internet based companies experienced substantial stock price appreciation. Employees of these companies were suddenly wealthy and exercised their stock options. Given the strength of the companies in the market many employees chose to hold the shares for further appreciation. When the bottom fell out and the share prices dropped these same employees discovered that their tax bill, based on market price at exercise, was greater than the now depressed value of the shares. There were many variations on this theme but the net result was the same; when the share prices plummeted the option value disappeared and the option owner found himself with liabilities but no assets left to cover them.

An idea often considered is to hedge the exercised shares by purchasing a corresponding put option while waiting for twelve months to pass in order to receive long-term gains treatment. Unfortunately this does not work. Such a strategy suspends the holding period in the eyes of the IRS and the holding period for capital gains purposes remains suspended as long as the put is in place. Fortunately all is not lost. With proper planning and a clear vision of what employee stock options can and cannot do an investor can design a strategy to protect against catastrophic downside loss while allowing participation in the ongoing success of the company. With a clear-eyed hard headed analysis the option owner can greatly increase the probability of meeting their long-term financial objectives.

Devin Pope, MBA, CFP / Senior Wealth Advisor
Albion Financial Group
dpope@albionfinancial.com
(801) 487-3700