Many companies provide stock options as equity compensation because they encourage employees to increase the value of their company through their work. It creates the potential for a tremendous win-win situation: employers benefit from an incentivized team that works to grow the company, and employees benefit from the subsequent increase in the value of the company’s stock.
If you’re receiving stock options as part of your compensation, it’s important to understand how they work and the steps you need to take to make the most out of this opportunity. In this blog post, we’ll provide an overview of stock options and the process of exercising and, ultimately, selling them. With this understanding, you’ll be ready to start taking concrete steps toward building a stock option strategy that supports your short- and long-term financial goals.
Types of Stock Options
First, it’s important to understand what kind of stock options you have. The two basic types of stock options that companies can provide as equity compensation are incentive stock options (ISOs) and non-qualified stock options (NSOs). NSOs are very common because there is no tax-code limit to the total number or value of NSOs that a company can grant, and they can be granted to not only employees but also officers, directors, contractors, consultants, and others.
ISOs, on the other hand, can be granted only to employees, and a maximum of $100,000 aggregate grant value can become exercisable in any calendar year. ISOs are non-transferrable. However, the gains on ISOs qualify for special tax treatment when certain conditions are met.
Vesting
When an employer offers stock options as equity compensation, these options must go through vesting. Vesting is typically based on time in service. Employee stock options also usually have a “cliff,” or a specific length of time employees must work with a company before they can begin receiving them.
For example, an employer may offer 20,000 stock options over a period of four years with a one-year cliff, after which an employee can exercise 25% of the options (or 5,000). After the one-year cliff, the employer will dispense the stock options at regular intervals (often quarterly, bi-annually, or annually) until all 20,000 have vested. If the employee leaves the company before the one-year cliff, they will lose all their stock options. After the cliff, an employee who leaves the company will typically lose the portion of options that remain unvested. Be aware, however, that even vested options must be exercised within a specified period after leaving a company; in the case of ISOs, this is generally 90 days, but for NSOs, it may be up to ten years.
Stock Option Exercise
Exercising stock options is the process of purchasing shares of the underlying stock. Typically, stock options must vest before they can be exercised. In some cases, however, employers allow early exercise of stock options, which creates the potential for important tax benefits.
Tax Consequences of Exercising Stock Options
The tax consequences of exercising stock option depend on their type. Exercising ISOs has no impact on the regular income tax calculation. However, the difference between the exercise price and the shares’ current fair market value (known as the bargain element of the exercise) must be included in the alternative minimum tax (AMT) calculation. This doesn’t necessarily mean you’ll owe additional taxes, but it’s important to use income and tax projections to understand the potential tax impact before you exercise ISOs.
When employees exercise NSOs, the bargain element is reported as employment compensation and taxed as regular income. As a result, exercising NSOs can present a significant financial challenge for employees: in addition to paying the strike price, they also must pay taxes on gains they haven’t yet realized—and may not be able to realize for months or even years.
Selling Your Company Stock
As with any investment, stocks that you purchase with options must be held for longer than one year to qualify for long-term capital gains tax treatment. This can provide substantial tax savings over short-term capital gains tax, which is equivalent to the regular income tax rate. To maintain the beneficial tax treatment of their bargain element, ISOs must also be held for more than two years after the grant date. If they’re sold earlier, the bargain element becomes subject to regular income tax (just like NSOs).
It's also important to know if your stock meets the criteria for qualified small business stock (QSBS). If so, holding these shares for more than five years could result in all or a portion of your gains being exempt from federal income tax. You can learn more about QSBS in our article, What Should I Know About Qualified Small Business Stock?
Navigating the Complex Stock Option Landscape
Stock options present a valuable opportunity for employees to share in their company's success. However, careful planning and strategic execution are essential. By understanding the differences between option types and their tax consequences, employees can get more out of their equity compensation. At WRP Wealth, we’re experts at navigating the complex landscape of equity compensation. Employee stock options come with an overwhelming array of complicated, time-sensitive, and highly consequential decisions to make. WRP is here to provide the insight and guidance you need to make well informed choices that support your financial success.
Our team specializes in helping employees make the most of their equity compensation. From developing comprehensive financial plans to implementing tax strategies, we tailor our services to align with each client’s unique goals and circumstances. With our strategic guidance, you can exercise your stock options confidently, knowing you have a team of experts by your side.
To learn more about how we can help you reach your financial goals, explore our stock options planning services, see the insights we share on our blog, or browse our library of free resources.