Stock Options 101: The Essentials

Matt Simon, myStockOptions.com

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 generally defer federal income 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 should know to help you 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 U.S. federal 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.

Note: 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).

Example: If you are granted an option to purchase 5,000 shares of company stock when the company's stock price is $10 per share:

• Your exercise price is $10.
  
  
• Under the vesting schedule, 25% of the option vests per year over four years (i.e., 1,250 shares subject to option become exercisable per year).
  
  
• By the time you have worked at the company for four years after the grant date, all of the option has become exercisable.
  
  
• Meanwhile, the company's stock price rises to $15 in Year 4.
  
  
• The option gives 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).
  
  
• 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).

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.

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: Let’s say you are granted an option to purchase 1,000 shares of company stock 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 option with respect to those 1,000 shares 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 means to do so and if the plan allows, 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 income 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.

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. 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 any portion of the option is not exercised before the expiration of the grant term, it is irrevocably forfeited pursuant to the terms of the plan.

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 and changes 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.

Two Types of Stock Options

Companies can grant two kinds of stock options: non-qualified stock options (NQSOs), the most common type, and incentive stock options (ISOs), which offer some tax benefits but also may trigger alternative minimum tax (AMT) liability.

Non-qualified Stock Options

A non-qualified stock option (NQSO) is a type of stock option that does not qualify for special favorable tax treatment under the U.S. Internal Revenue Code. Thus, the word non-qualified 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 may owe taxes when you exercise NQSOs. For tax purposes, the exercise spread is ordinary income and is therefore reported on your IRS Form W-2 or for the calendar year of exercise.

Example: Let’s say 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—federal and state (if applicable) income taxes, 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

If certain criteria are met, incentive stock options (ISOs) qualify for special tax treatment under the Internal Revenue Code. Employers are not required to withhold Social Security, Medicare or federal income tax. Employees are generally not subject to federal income tax upon grant or exercise of an ISO. However, to qualify they must meet rigid criteria under the Internal Revenue 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) by an individual in any calendar year. Also, for an employee to retain the special ISO treatment after leaving the company, the ISOs must be exercised within three months after the date of employment termination.

ISO taxation is complex. You must understand how the alternative minimum tax can affect you.

After you exercise ISOs, if you hold the acquired shares for more than two years from the date of grant and more than 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, you may be subject to the alternative minimum tax (AMT) on the spread at exercise if you hold the shares acquired from ISOs beyond the calendar year of exercise. This can be problematic if you are faced with the AMT on theoretical gains but the company's stock price then drops, leaving you with a big tax bill on income that has evaporated.

Summary: Core Features of Stock Options

• Stock options provide the right to buy a specified number of company shares at a fixed price.
   

• There is a vesting period before options are exercisable.
  
  
• Exercising stock options means you’ve purchased and own company shares.
  
  
• There are two types: non-qualified and incentive.
  
  
• Stock options typically provide for a fixed grant term, after which any unexercised portion of the option expires.
  
  
• Job changes and life events can have an impact on your options; check your plan documents.
  
  
• Stock options have specific tax treatments; you should familiarize yourself with plan documents and consult a tax advisor to understand the tax implications of your decisions.