Employee Stock Options

 In Investing


Many companies offer employees stock options for the company they work for. They usually entail the employee receiving the right to purchase a specified number of shares of the employer’s stock at a specified price over a stated time period. The employee usually must remain with the company for a certain number of years (the vesting period) to be able to use the option. There are two different kinds of employee stock options, each with different characteristics that we will lay out the differences for. First, here’s a quick example of how an employee stock option may be set up.

Joe works at Company X and is offered stock options when he starts. He must work there for three years to be fully vested to earn the right to exercise the options. When he begins working, Company X’s stock price is $24 and they give him the option to purchase 100 shares of the stock at $27 over the next five years. Four years later, that stock is trading at $30. Now Joe has the option to buy the stock at $27 and sell it for $30 or hold onto it in hopes of more gains.

There are two types of employee stock options, nonqualified (NSO’s) and incentive (ISO’s). NSO’s are more common and are basically treated as a form of compensation. When they are exercised, the difference between the current market price and strike (offering) price is reported as wages on the tax returns of the employee and employer. Therefore, the employee is taxed as ordinary income while the company receives a tax deduction as salary expense. In Joe’s example, he could add $300 to his normal salary if he sells them and pay his usual income tax on that money.

ISO’s can be more advantageous to the employee than NSO’s if done properly. There are generally no tax consequences to the employer, and if the purchased stock is held for at least two years after it was granted, or one year after it was exercised, the profits are reported as long-term capital gains. Although, these profits are normally recognized when calculating the Alternative Minimum Tax (AMT), but that’s something we will cover later. Say Joe exercised that option for $27 but didn’t sell it right away, and instead sold it two years later at the same $30 price. It’s the same $300 gain, but instead it will be taxed as a long-term capital gain, which is usually a lower rate, therefore putting a bit more money in his pocket.

Hopefully this may help employers better decide which stock options may be right for their company, or employees better understand what their options are for their stock options. They can be a great incentive for employees to work hard because if they succeed, the company’s stock price will hopefully rise and that’s something everyone can reap the benefits of.

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