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.
- ISOs have no ordinary tax implication during grant or exercise. However, ISOs are a preferred tax item for calculating alternative minimum tax (AMT).
- 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.
- Holding period requirements.
- 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.
- 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).
- 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.
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.