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Stock Options 101: The Basics

Author: Matt Simon, myStockOptions.com

If you are reading this article, your company has probably granted you stock options. Congratulations. Stock options give you a potential share in the growth of your company's value without any financial risk to you until you exercise the options and buy shares of the company's stock. Moreover, while cash bonuses and most other forms of compensation are taxable when you receive them, stock options defer taxes until you exercise them. Before you exercise your options, their built-in value is subject to pre-tax growth — which can be significant.

This article explains the basic facts and terms that you must know to make the most of your stock options.

What Is A Stock Option?

A stock option is a contractual right that a company awards under a stock plan, which contains the company’s rules for its stock option grants. While some of the rules that govern stock options are dictated by tax and securities laws, many variables in the ways option grants work are left for each company to provide in its stock plan and in the grant agreement that recipients must often accept.

Alert: You should familiarize yourself with your stock plan and grant agreement before you take any action with your stock options.

Stock options give you the right to purchase a specified number of shares of the company's stock at a fixed price during a rigidly defined timeframe. The purchase is called the exercise, and the fixed price set at grant is called the exercise price. Typically, you must continue to work at the company for a specified length of time before you are allowed to exercise any of the stock options. That length of time is called the vesting period, which is characterized by a vesting schedule. Under a vesting schedule, an option grant can be set up so that it vests either all at once (cliff vesting) or in a series of parts over time (graded vesting). The adjacent graphic illustrates the concept of a typical graded vesting schedule.

Example: You are granted 5,000 stock options when the company's stock price is $10 per share.

  • Your exercise price is $10.
  • Under the vesting schedule, 25% of the options vest per year over four years (i.e. 1,250 options per year).
  • By the time you have continued to work at the company for four years after the grant date, all of the options have become exercisable.
  • Meanwhile, the company's stock price rises to $15.
  • The options give you the right to buy 5,000 shares of the company's stock at your exercise price of $10 per share rather than at the market price of $15 per share.
  • You can exercise when the options vest, or you can wait until later in the option term (see the next section).

While vesting periods for stock options are usually time-based, they can also be based on the achievement of specified goals, whether in corporate performance or employee performance.

Beware: Stock Options Will Expire If Not Exercised

Stock options always have a limited term during which they can be exercised. The most common term is 10 years from the date of grant. Of course, after the vesting period has elapsed, the actual amount of time to exercise the options will be shorter (e.g. six years after a four-year vesting requirement). If the options are not exercised before the expiration of the grant term, they are irrevocably forfeited.

Employees who leave the company before the vesting date usually forfeit their options. With vested options, departing employees typically have a strictly enforced timeframe (often 60 or 90 days) in which to exercise—they are almost never allowed the remainder of the original option term.

Alert: Events such as retirement, disability, or death can trigger different rules under your stock plan. You should understand what would happen to your grant upon the occurrence of major job events or life events.

How Do Stock Options Work?

Since the exercise price is nearly always the company's stock price on the grant date, stock options become valuable only if the stock price rises, thus creating a discount between the market price and your lower exercise price. However, any value in the stock options is entirely theoretical until you exercise them — i.e. until you pay money to buy the shares at the exercise price. After you have acquired the shares through this purchase, you own them outright, just as you would own shares bought on the open market.

Example: You are granted 1,000 stock options with an exercise price of $10 per share (i.e. the stock price on the date of grant). Subsequently, the stock price rises to $50. If you exercise the 1,000 options at that time, you will pay only $10,000 to obtain shares that are worth $50,000 on the open market.

Depending on the rules of your company's stock plan, options can be exercised in various ways. If you have the cash to do so, you can simply make a straightforward cash payment, or you can pay through a salary deduction. Alternatively, in a cashless exercise, shares are sold immediately at exercise to cover the exercise cost and the taxes.

Option Value Can Go Up Or Down

If your company's stock price rises, the discount between the stock price and the exercise price can make stock options very valuable. That potential for personal financial gain, which is directly aligned with the company's stock-price performance, is intended to motivate you to work hard to improve corporate value. In other words, what's good for your company is good for you.

However, by the same token, stock options can lose value too. If the stock price decreases after the grant date, the exercise price will be higher than the market price of the stock, making it pointless to exercise the options — you could buy the same shares for less on the open market. Options with an exercise price that is greater than the stock price are called underwater stock options.

Two Types Of Stock Options

Companies can grant two kinds of stock options:

  • nonqualified stock options (NQSOs), the most common type
  • incentive stock options (ISOs), which offer tax benefits but also raise the risk of the alternative minimum tax (AMT)

Nonqualified Stock Options

A nonqualified stock option (NQSO) is a type of stock option that does not qualify for special favorable tax treatment under the US Internal Revenue Code. Thus the word nonqualified applies to the tax treatment (not to eligibility or any other consideration). NQSOs are the most common form of stock option and may be granted to employees, officers, directors, contractors, and consultants.

You pay taxes when you exercise NQSOs. For tax purposes, the exercise spread is compensation income and is therefore reported on your IRS Form W-2 for the calendar year of exercise.

Example: Your stock options 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.

Your company will withhold taxes—income tax, Social Security, and Medicare — when you exercise NQSOs.

When you sell the shares, whether immediately or after a holding period, your proceeds are taxed under the rules for capital gains and losses. You report the stock sale on Form 8949 and Schedule D of your IRS Form 1040 tax return.

Incentive Stock Options

Incentive stock options (ISOs) qualify for special tax treatment under the Internal Revenue Code and are not subject to Social Security, Medicare, or withholding taxes. However, to qualify they must meet rigid criteria under the tax code. ISOs can be granted only to employees, not to consultants or contractors. There is a $100,000 limit on the aggregate grant value of ISOs that may first become exercisable (i.e. vest) in any calendar year. Also, for an employee to retain the special ISO tax benefits after leaving the company, the ISOs must be exercised within three months after the date of employment termination.

After you exercise ISOs, if you hold the acquired shares for at least two years from the date of grant and one year from the date of exercise, you incur favorable long-term capital gains tax (rather than ordinary income tax) on all appreciation over the exercise price. However, the paper gains on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to the alternative minimum tax (AMT). This can be problematic if you are hit with the AMT on theoretical gains but the company's stock price then plummets, leaving you with a big tax bill on income that has evaporated.

Alert: If you have been granted ISOs, you must understand how the alternative minimum tax can affect you.

The Next Step: Understanding Stock Option Taxation

Stock option taxation is an important subject for all option holders to understand. Now that you know the basic workings of stock options, you should learn the details of their tax treatment.

Matt Simon is the Editor & Content-Manager at myStockOptions.com.

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