Employers commonly offer stock options to employees as a way of fostering a greater sense of ownership and encouraging long-term commitment. Two common types of stock options offered to employees are incentive stock options (ISOs) and non-qualified stock options (NSOs).
A stock option is a contract that gives its holder the right to purchase stock at a given price (the “strike price” or the “exercise price”) within a set period of time but without any obligation to do so. The holder of an option is said to “exercise” the option by purchasing stock within the time frame allowed, regardless of the market value at the time of exercise. Thus, if the market price rises, the holder of an option can purchase stock at the predetermined exercise price, then turn right around and sell the stock for an immediate profit. All options come with an expiration date.
An employee usually cannot exercise an option until it “vests,” which means that you fully own the option. Vesting occurs on a predetermined schedule, usually after a fixed amount of time, but vesting can also be based on performance milestones. Some employers may offer gradual vesting schedules, and other options vest on “cliff” schedules (where most or all of the options vest at one time). An employer may offer an early exercise provision, allowing options to be exercised before they vest. In the event of early vesting, shares of stock will typically follow the same vesting schedule as the original option contract; if the employee leaves the company before the shares vest, the contract may give the company the right to buy back the shares or the employee may forfeit the unvested shares. The particulars all depend on the terms of the option contract.
The “bargain element” is the difference between the market price at the time of exercise and the grant price of the option. For instance, let’s say an employee is granted the option to purchase up to 1,000 shares of stock at $20 per share, the market price increases to $50 per share, and the employee exercises the full option. The employee pays $20,000 cash and receives shares of stock valued at $50,000. The bargain element is the $30,000 profit that the employee will have realized on the transaction. The stock can be sold at any time, even immediately upon exercise of the option, but in order for the sale profits to qualify as capital gains rather than ordinary income, the shareholder must hold the shares for at least one year. (1)
A “clawback” provision gives a company the right to reclaim an option or to buy back shares of stock if certain triggering events occur. Common reasons for clawbacks include financial insolvency of the company or termination of employment. An employment contract can potentially allow for clawbacks even after an option is vested. (2)
NSOs provide a simple way for employers to incentivize employee performance, but they do not offer the same tax advantages of an ISO. Upon exercise of NSOs, the employee pays ordinary income tax on the difference between the exercise price and the market price (the bargain element). Since ordinary income is taxed at a higher rate than long-term capital gains, this can make NSOs less attractive for individuals with higher income levels, but the simplicity of NSOs allows employers to offer this type of option more broadly.
ISOs are the more complicated type of option, more commonly offered to senior management. ISOs can sometimes offer tax advantages over other types of stock options, but with some restrictions. When an employee exercises an ISO, the profits can qualify as capital gains under two conditions: the employee cannot sell the stock until one year after exercising the option and two years after the grant date. (3) Additionally, the sale of stock purchased from an ISO exercise can potentially incur liability for alternative minimum tax for employees regardless of compensation levels; you will need to consult your financial advisor or tax professional to determine if this applies in your case.
Stock options, like employee stock purchase plans, should be considered as components of your financial toolbox. Stock inherently carries risk, and there is of course no guarantee that an option will have any value, as the company’s stock price could drop after grant. There is no one-size-fits-all answer to the question of whether company stock is the best place to invest for your retirement. If your employer offers stock options, or if you would like an overall evaluation of your retirement strategy, call 440-505-5704 or email jbrown@Wadvocate.com to schedule an appointment.
John D. Brown is a Partner and CERTIFIED FINANCIAL PLANNER® (CFP®) at Wealth Advocate Group, LLC – an independent, fee-based wealth management company. With over 10 years of experience in the financial industry and an extensive background in accounting, John provides specialized services to senior executive clients who would like assistance managing their concentrated securities, stock options, restricted stock, as well as aid in managing the risks and tax burdens associated with their compensation. John has a bachelor’s degree in accounting and financial management from Hillsdale College. To learn more about John, connect with him on LinkedIn.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Wealth Advocate Group and LPL Financial do not provide tax advice or services. Please consult your tax advisor regarding your specific situation.
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