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Companies have found a clever way to both supplement employee compensation and encourage productivity/loyalty: the use of stock options. In a broad sense, stock options are a valuable way that companies can compensate employees by giving them a percentage of ownership (click here for a more detailed understanding of how stock options work). As more companies are engaging in this type of rewards program, it is important to understand the implications of stock option ownership.
Types of Employee Stock Options
The most common type of stock option is a Non-Qualified Stock Option (NQSO). Companies can offer NQSOs to employees, contractors, or consultants. The term ‘non-qualified’ refers to the fact that this option doesn’t qualify for specialized tax treatment with the IRS.
The second type of stock options are Incentive Stock Options (ISO), which can only be issued to employees. There are several rules unique to this type of option. One is a limit of $100,000 aggregately on the value of the ISO grant that can be vested in any calendar year. Employees must also exercise their shares within three months after they terminate their employment and are subject to specialized tax treatment. Overall, ISOs are less popular, so we will focus on NQSOs for this article.
Three Ways to Exercise Options
- Cash for stock: This simply means buying stock with cash, which gives the owner the maximum investment in company stock. The purchaser will still have to pay broker commissions, fees, and taxes.
- Cashless and sell: The owner purchases shares and sells them right away. They may be able to use the proceeds of the sale to cover the purchase price, commissions, fees, and taxes.
- Cashless and keep stock: Owners exercise their option and sell only enough to cover the price, commissions, fees, and taxes. They keep the rest in the form of company stock.
What Are the Tax Implications of Exercising Non-Qualified Stock Options?
With NQSOs, taxes are paid at their ordinary income tax rate on the difference between the stock price and price at exercise. The stock price on this date becomes the cost basis of those shares. This income is usually reported on the owner’s paystub and the company withholds taxes (e.g., Social Security, Medicare, and income tax) when the NQSOs are exercised.
Example: Your NQSOs have an exercise price of $10 per share. You exercise them when the price of your company stock is $12 per share. You have a $2 spread ($12 – $10) and thus $2 per share in ordinary income.
When stockowners sell their shares, they get taxed under the rules for capital gains and losses, depending on how the stock’s price has moved.
Example: You receive a grant of NQSOs and exercise them after vesting.
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- Your exercise price is $12 and the market price (used to calculate the spread at exercise) is $18. At exercise, you have $6 per share ($18 – $12) of ordinary income and the new cost basis per share is $18.
- You sell the shares more than one year later (making it a long-term holding) when the price is $26. You have $8 ($26 – $18) of long-term capital gains at sale.
- The capital gains are taxed at 15% or 20%, depending on your income.
Given the preferential tax treatment of long-term capital gains, it is usually recommended that the owner hold onto their exercised shares for a year before selling. However, some owners may also choose to sell the day of exercise, receiving the market value of the shares with zero gains realized. This decision is entirely dependent on each owner’s unique situation and preference.
As always, please consult your advisor or tax preparer to determine how your personal finances and tax situation could be impacted by these trading vehicles or investment tools. If you don’t have either, the team at Glassman Wealth would be happy to talk with you about your options (no pun intended)!