An employee stock option plan can be a lucrative investment instrument if properly managed. For this reason, these plans have long served as a successful tool to attract top executives, and in recent years become a popular means to lure non-executive employees. Unfortunately, some still fail to take full advantage of the money generated by their employee stock. Understanding the nature of stock options, taxation and the impact on personal income is key to maximizing such a potentially lucrative perk.

What's an Employee Stock Option?
An employee stock option is a contract issued by an employer to an employee to purchase a set amount of shares of company stock at a fixed price for a limited period of time. There are two broad classifications of stock options issued: non-qualified stock options (NSO) and incentive stock options (ISO).

Non-qualified stock options differ from incentive stock options in two ways. First, NSOs are offered to non-executive employees and outside directors or consultants. By contrast, ISOs are strictly reserved for employees (more specifically, executives) of the company. Secondly, nonqualified options do not receive special federal tax treatment, while incentive stock options are given favorable tax treatment because they meet specific statutory rules described by the Internal Revenue Code (more on this favorable tax treatment is provided below).

NSO and ISO plans share a common trait: they can feel complex! Transactions within these plans must follow specific terms set forth by the employer agreement and the Internal Revenue Code.

Grant Date, Expiration, Vesting and Exercise
To begin, employees are typically not granted full ownership of the options on the initiation date of the contract (also know as the grant date). They must comply with a specific schedule known as the vesting schedule when exercising their options. The vesting schedule begins on the day the options are granted and lists the dates that an employee is able to exercise a specific number of shares. For example, an employer may grant 1,000 shares on the grant date, but a year from that date, 200 shares will vest (the employee is given the right to exercise 200 of the 1,000 shares initially granted). The year after, another 200 shares are vested, and so on. The vesting schedule is followed by an expiration date. On this date, the employer no longer reserves the right for its employee to purchase company stock under the terms of the agreement.

An employee stock option is granted at a specific price, known as the exercise price. It is the price per share that an employee must pay to exercise his or her options. The exercise price is important because it is used to determine the gain (called the bargain element) and the tax payable on the contract. The bargain element is calculated by subtracting the exercise price from the market price of the company stock on the date the option is exercised.

Taxing Employee Stock Options
The Internal Revenue Code also has a set of rules that an owner must obey to avoid paying hefty taxes on his or her contracts. The taxation of stock option contracts depends on the type of option owned.

For non-qualified stock options (NSO):

  • The grant is not a taxable event.
  • Taxation begins at the time of exercise. The bargain element of a non-qualified stock option is considered "compensation" and is taxed at ordinary income tax rates. For example, if an employee is granted 100 shares of Stock A at an exercise price of $25, the market value of the stock at the time of exercise is $50. The bargain element on the contract is ($50 - $25) x 100=$2,500. Note that we are assuming that these shares are 100% vested.
  • The sale of the security triggers another taxable event: If the employee decides to sell the shares immediately (or less than a year from exercise), the transaction will be reported as a short-term capital gain (or loss) and will be subject to tax at ordinary income tax rates. If the employee decides to sell the shares a year after the exercise, the sale will be reported as a long-term capital gain (or loss) and the tax will be reduced.

Incentive stock options (ISO) receive special tax treatment:

  • The grant is not a taxable transaction.
  • No taxable events are reported at exercise; however, the bargain element of an incentive stock option may trigger alternative minimum tax (AMT).
  • The first taxable event occurs at the sale. If the shares are sold immediately after they are exercised, the bargain element is treated as ordinary income.
  • The gain on the contract will be treated as a long-term capital gain if the following rule is honored: the stocks have to be held for 12 months after exercise and should not be sold until two years after the grant date. For example, suppose that Stock A is granted on January 1, 2007 (100% vested). The executive exercises the options on June 1, 2008. Should he or she wish to report the gain on the contract as a long-term capital gain, the stock cannot be sold before June 1, 2009.

Other Considerations
Although the timing of a stock option strategy is important, there are other considerations to be made. Another key aspect of stock option planning is the effect that these instruments will have on overall asset allocation. For any investment plan to be successful, the assets have to be properly diversified. An employee should be wary of concentrated positions on any company's stock. Most financial advisors suggest that company stock should represent 20% (at most) of the overall investment plan. While you may feel comfortable investing a larger percentage of your portfolio in your own company, it's simply safer to diversify. Consult a financial and/or tax specialist to determine the best execution plan for your portfolio.

Bottom Line
Conceptually, options are an attractive payment method. What better way to encourage employees to participate in the growth of a company than by offering them a piece of the pie? In practice, however, redemption and taxation of these instruments can be quite complicated. Most employees do not understand the tax effects of owning and exercising their options. As a result, they can be heavily penalized by Uncle Sam and often miss out on some of the money generated by these contracts. Remember that selling your employee stock immediately after exercise will induce the higher short-term capital gains tax. Waiting until the sale qualifies for the lesser long-term capital gains tax can save you hundreds, or even thousands.

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