Employee Benefits For Transitioning Personnel-Employee Stock Options

There are many employer benefits that just aren’t available to servicemembers.  Before separating from service, it’s important to understand what types of benefits exist, and what impact they may have on our personal finances.  This article focuses on employee stock options, specifically:

  • What are stock options?
  • Why do stock options exist?
  • Why do employers offer employee  stock options?
  • What type of employee stock options are there?
  • Tax treatment of employee stock options

What is a stock option?

A stock option is simply a contract that allows you to purchase or sell shares of stock (usually in blocks of 100 shares), for a certain period of time, for a certain price.  If, after that time, the owner has not exercised the option, it expires and is worthless.  You can buy stock option contracts through most online brokers.

For example, someone might own a Microsoft call option contract (call options are options that allow you to purchase stock at a predetermined price).  This contract might call for the right to purchase 100 shares of Microsoft at $25 per share.  If Microsoft’s stock price is above $25, the option has intrinsic value, or ‘in the money.’  If the stock price is equal to $25, the option is said to be ‘at the money,’ and if it is less than $25, the option is ‘out of the money.’  In the last two cases, the option does not have intrinsic value.

Why do stock options exist?

Stock options exist primarily because there are people who want to use leverage to expand their possible returns.  Using the above example, you could either purchase Microsoft stock directly.  This would cost $2,500 (plus trading fees).  At this point, you now have a position in Microsoft stock.  You receive all the dividends that Microsoft issues.  However, any changes in stock price directly impact your stock’s value.  In this case, if your stock’s value declines, your position actually goes down.  If you sell at this point, you would lose the difference between what you paid and what you sold it for.

Conversely, you can purchase an option at approximately its intrinsic value (plus trading fees).  The cost of the option would depend on the cost of Microsoft’s stock at the time of purchase, and how much time remains until the option expires.  While this calculation is too complex for this article, we can safely assume that this cost would be considerably less than $2,500.  Having an option allows a few more options, depending on the stock’s direction:

  • If the stock appreciates in value, you can exercise the option & own the stock. You can even sell the stock immediately after you exercise the option and pocket the difference (minus taxes).
  • If the stock appreciates in value, you can sell the option to someone else. In this case, you would still make a profit.  However, that profit would only be the difference between the purchase price & sale price of your option, not the stock itself.
  • If the stock loses value & the option expires worthless…you can walk away.

The last part is key…investing in an option allows you to use leverage in order to participate in stock gains without taking the full risk of owning the stock itself.  While there are various pros and cons of owning stock options, this is where we transition to employee stock options.

Why do employers issue stock options?

Employers offer a variety of benefits in order to compensate, attract and retain talent that supports their organization’s goals.  When a company grants employee stock options (ESOs), they’re likely trying to appeal to people who:

  • Want to share in the company’s long-term success
  • Feel as though they are a powerful contributor to that success

Additionally, ESOs allow employees to use the power of leverage to avoid putting a significant amount of their own money into the company’s stock.  Instead, ESOs are usually kept in a separate account, known as an employee stock option plan (ESOP).  This should not be confused with employee stock ownership plans, also known as ESOPs.

There are a couple of differences between ESOs and traded stock options:

  • ESOs are usually not traded on any exchange. Since they are a contract between employer and employee, ESOs are usually set aside for the employee’s benefit only.
  • There usually are restrictions on when employees can exercise ESOs.
  • Tax treatment. Since ESOs are a form of employee compensation, there are different tax treatments for ESOs.  This tax treatment depends on the type of ESO.

What types of employee stock options are there?

There are two types of ESOs:  statutory, and non-statutory.

Statutory stock options are sometimes also known as incentive stock options (ISOs) or qualified stock options (QSOs).  Statutory stock options qualify for preferential tax treatment for employees.  However, this preferential tax treatment is complex and does require some hurdles, specifically regarding holding periods.  We’ll get to this later.  The Internal Revenue Code, and IRS Publication 525 (Employee Compensation) contain detailed information on what constitutes a statutory stock option.

Non-statutory stock options are also known as non-qualified stock options (NSOs).  NSOs are any stock options that do not qualify as a statutory stock option.  This sounds fairly obvious.  However, it’s important that there are two ways this can happen.  The first is if a company specifically grants an ESO as a non-qualified stock option.  In other words, that was the company’s intent.  The second is if the company grants an ISO that fails to meet the qualifying criteria for preferential tax treatment.  This most likely happens when the underlying stock is disposed of without meeting the holding requirements, and is known as a disqualifying disposition.

What is involved with ESOs?

There are three things that impact the tax treatment of ESOs.

  • Grant date.  This is when the employer grants the options to the employee.  At the time of grant, the employee only has the option to buy stock, not the stock itself.
  • Exercise date.  This is when the employee has decided to exercise the option to purchase the stock itself.
  • Sale date. This is when the employee has decided to sell the stock.

What is the tax treatment for ESOs? 

Tax treatment is the primary difference between NSOs & ISOs.  Since NSOs are simpler, we’ll cover them first:

NSO tax treatment for the employee.  Upon grant, the employee may be subject to ordinary income tax.  Whether or not there is taxation upon NSO grant depends on whether there are restrictions on the employee’s ability to exercise the NSO, and whether the exercise price is less than the stock’s market price at the time of grant.  More information can be found in Section 409A of the Internal Revenue Code, under Nonqualified Deferred Compensation.

Upon exercise, the employee is subject to ordinary income tax (not capital gains tax) on the difference between the option price and the stock price when the option was exercised.

For example, an employee holds options to purchase 1,000 shares of Microsoft at $25 per share.  Microsoft stock is currently $40 per share.  If the employee exercises these options today, he or she would be subject to ordinary income on the difference ($15 per share, or $15,000).   This difference is also known as the bargain element.  The employer is also required to withhold all applicable taxes on NSO exercise, just as if it were normal pay.

Upon sale, the employee would be subject to normal rules surrounding sale of stock.  Sales of stock owned for a year or less are considered short term capital gains or losses.  Short term capital gains & losses are netted out with long term capital gains & losses on Schedule D of your tax return.  Any remaining short term capital gains are subject to ordinary income tax.

NSO tax treatment for the employer.  Upon employee exercise, the employer is eligible to deduct the full bargain element as employee compensation.  From the employer’s point of view, this essentially is employee compensation.  It’s understandable why most employers prefer to issue NSOs over ISOs—NSOs allow for simplicity & better tax treatment for employee compensation.

ISO tax treatment for the employee.

  1. ISOs have no ordinary tax implication during grant or exercise. However, ISOs are a preferred tax item for calculating alternative minimum tax (AMT).
  2. Gains attributed to ISO stock sale are calculated at long-term capital gains rates. This is due to the holding period requirements for an ESO to remain an ISO.
  3. Holding period requirements.
    1. Shares must not be disposed within two years of the ISO grant date or one year of the ISO exercise date. The fact that ISOs must not be sold within 1 year of exercise date automatically confers long term capital gains (or loss) treatment on any ESOs that remain ISOs.
    2. However, ISOs must be exercised within 3 months of an employee’s departure from the company (or 1 year if separation is due to a disability).
  4. ISO Example:
    • January 10, 2015- share value is $10: company issues an option to purchase 1 share of stock with a strike price of $10.
    • January 11, 2016- share value is $50: employee exercises the option and pays the company $10 to purchase 1 share of stock.
    • January 12, 2017- share value is $100: employee sells the share for $100. Employee has $90 of gain that is treated as long-term capital gain.

ISO tax treatment for the employer.

Employers receive zero preferential tax treatment for the proper grant, exercise, or stock sale of an ISO.  However, any stock sales that are deemed disqualifying dispositions change an ISO to an NSO.  In that case, the employer can take all applicable tax deductions as if it had granted an NSO.

Employee Stock Options Example

I recently was talking with a friend who had received ISOs through her employer.  At the time she received her ISOs, her employer was a start-up, and ISOs were one of the main reasons she came to work at the company.

Fast forward 18 months.  The company, which was doing better than expected, got bought out by a larger firm.  As a result, all employee stock options were redeemed, and the employees’ stock was subsequently purchased from the employees.  Although this was due to no fault of my friend, this transaction effectively transformed her ISOs into NSOs.

As a result, she must realize ordinary income on the entire value of the option.  Not only that, but because the stocks were sold immediately after the options were exercised, she must realize ordinary income on the appreciation of the stock.  This normally would have qualified for preferred tax treatment as capital gains had they remained ISOs.

Conclusion

While many transitioning personnel might not find jobs that grant ESOs, there are companies that do award them.  When shopping around for compensation packages, it definitely pays to understand what type of stock options you might be eligible for, and to have a better understanding of how to maximize their benefit.

If you have a concern about how your employee stock options might affect your financial situation, you should contact a fee-only financial planner who can help you figure out what’s right for you.

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Financial Regulation Offices (by State)

While the gossip of the moment is about the fiduciary standard, it’s important to realize that people can fall victim to bad financial advice, even from a fiduciary.  Most fee-only financial planners are registered as investment advisers.

Every registered investment advisor (RIA) is required to file form ADV, which contains a lot of information.  RIAs are also required to register with either a state regulatory office or the Securities & Exchange Commission.

These regulatory offices are responsible for ensuring that RIAs comply with federal and state laws.  They should also be your first checking point to ensure:

  • The person you’re about to hire is actually registered and that they are who they say they are
  • You know of any disclosures that might impact your decision to hire this person. Disclosures can range from conflicts of interest to financial issues (like bankruptcy), to criminal convictions.  You know, things that might make you want to NOT hire this person.

Below is a list of the regulatory websites by state, as well as the SEC’s website. Continue reading

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Five Financial Lessons I Learned From My Mother

My mother isn’t what you would call a financial planner.  She isn’t even really that savvy when it comes to money.  In fact, a few years ago, she asked me to help her manage her finances.  When I looked at her financial picture, though, I realized that she was much better off that I had thought.  Since then, I’ve come to learn some personal finance lessons from my mother…lessons that I did not learn in the CFP curriculum.  Below are five of them: Continue reading

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State Community College System Websites (by State)

College affordability is a hot topic.  Community colleges can provide a cost effective way to obtain a college diploma from a public university.  Many states allow community college attendees to transfer credits within their public university system.

Not only that, but community colleges can provide trade certification education, continuing education credits, or refresher training on any number of topics.  Not only that, but they can do this at a fraction of the price of most institutions.

Below are the links to each state’s community college system’s website: Continue reading

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Why SGLI Isn’t Enough Life Insurance For Most Military Families (Part 2)

This is the second of a two-part article, designed to outline why SGLI isn’t enough life insurance for most military families.  Part one discussed SGLI coverage on the servicemember.  This article discusses the reason why Familymember SGLI (FSGLI) is usually not enough to cover the death of a spouse.

Overview

Every successful military family succeeds not just because of the military career, but because of the spouse.  In this article, we’re going to discuss three major factors that should be considered when insuring a supportive spouse.  Continue reading

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Why SGLI Isn’t Enough Life Insurance For Most Military Families (Part 1)

Most people know that SGLI is the cheapest life insurance available.  At $28.00/month for $400,000 in coverage (or about 7 cents/month for every $1,000 in coverage)—by far.  Unfortunately, this creates two problems:

  1. SGLI’s pricing leads people into thinking that all life insurance should be this cheap.
  2. The $400,000 ceiling leads many people into thinking that all they need is $400,000 in life insurance, regardless of what’s going on in their life.

Both of these assumptions leave many families in a very precarious financial situation.  This article won’t address why commercial life insurance (even term insurance) isn’t as inexpensive as SGLI.  It also won’t give you a ‘one size fits all answer on how much life insurance you need.’  There is no ‘best’ answer here.  The best answer is one that helps you sleep at night.

This two-part article will outline three ways many fee-only financial planners help families figure out their life insurance needs so they can obtain coverage that’s appropriate for them.  Part one focuses on determining the life insurance needs to cover the primary breadwinner’s lost income.  There are families where the servicemember is not necessarily the primary breadwinner.  However, for purposes of this article, we will assume that the primary breadwinner is the servicemember. Continue reading

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10 Considerations About the Blended Retirement System (BRS)

Recently, I sat down with someone who asked me whether she should take the military’s Blended Retirement System (BRS).  As most people know, the BRS is the military’s attempt to slowly move away from a defined benefit pension to a defined contribution pension.  So her question was, “Should I take some money now, in exchange for a lower pension later?”

As a member of the military community, I’ve seen this discussion a lot.  There are any number of opinions across the spectrum.  As a financial planner, though, I’ve seen less discussion.  However, from my experience, personal finance is more personal than finance.  In other words, it’s not just crunching the numbers.

Immediately, these thoughts came to my mind.  Granted, this is not for the majority of people who only stay for their initial obligated service (enlistment or officer obligation).  Nor is this for those who truly don’t plan to stay in for at least 20 years.  However, if there is even an inkling that you might, you should consider these thoughts: Continue reading

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5 Home Purchase Considerations For Your Military Transition

When leaving the military, one of the most important considerations is where to live.  Should we buy a house?  Should we rent?  When making a home purchase decision, you need to understand how complex your situation is.

For example, staying local during your transition might be a lot simpler than relocating.  But relocation isn’t the only factor.  You need to truly understand all of the moving pieces so that you can make a truly informed decision.

Let’s look at five considerations when trying to decide whether a home purchase is right for you. Continue reading

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When Departing FROM the Military, What Are You Going TO?

The military does a great job of assimilating this varied group of people into one common purpose.  However, we all leave the military, for one reason or another.  And that’s where there’s room for improvement.

The military has a moral (and legal) responsibility to provide us transition resources.  However, it’s ultimately our job to make sure that the rest of our lives is as productive, fruitful, and rewarding as we want them to be.

Before we begin, it might occur to some people that the title of this article is grammatically incorrect.  As an English major, I can appreciate it.  And I hope that this title is grammatically incorrect enough to take an extra second to think about what your post-military life will look like.  That’s what this article aims to discuss. Continue reading

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Roth Conversions: Why Timing Is Important (Part Two)

In a previous Roth conversion article, we discussed the importance of timing when it comes to Roth conversions.  There are other Roth benefits, such as not having to worry about required minimum distributions (RMDs), and being able to take out qualifying contributions & conversions at any time.  However, there is a danger of overpaying for that privilege.

Let’s imagine a household currently in the highest tax bracket (39.6%).  They plan to eventually retire to the 15% tax bracket.  A Roth conversion today would cost that household more than twice as much than if they waited until they had to take RMDs.  Conversely, a family that is currently in the 15% bracket might save thousands of dollars by maximizing their conversions in their current tax bracket.

This article aims to discuss:

  • Why a military family’s tax bracket might change over time
  • When you might want to consider Roth conversions
  • When you might want to delay Roth conversions
  • Why you might want to hire a tax professional to help with tax planning
  • Why you might never want to convert to a Roth account at all

Continue reading

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