Employee Stock Options, A Primer for Employees

Executive compensation is the combination of salary, benefits and bonuses offered to executives and other top management in exchange for their efforts on behalf of an employer. A component of compensation typically reserved for executives and top management is equity compensation. This usually takes the form of stock options and/or restricted stock units (RSUs). Stock options and RSUs, unlike salaries and bonuses (cash compensation), are considered long-term incentives. These incentives may total 50% or more of an executive’s overall compensation. Because it can make up such a significant portion of compensation, it is important for those receiving equity compensation to maximize its value over time. In this article, we will focus on the more complex of the two long-term incentives—employee stock options.

What are Employee Stock Options?

An employee stock option is a contract between an employee and an employer. The actual contract or document is usually referred to as an option grant agreement. It allows you, as the employee, to purchase shares of a company within a specified time, at a predetermined price, known as the strike price or exercise price. The option is a right, not an obligation, meaning that you, as the option holder, need not exercise the option or actually purchase the stock. Until the option is exercised, it has no real value.

Stock options are favored by employers as an employee retention strategy because in most cases the options may not be exercised until some years after they are granted (typically four years) This incentivizes key employees to remain with the company during the interim and to work hard to grow the business which logically will increase the value of the company’s stock. The time between the grant of the option and when it is exercisable is known as the vesting period. Stock options, as part of a compensation package, are especially favored by start-up companies that are usually short on cash.

Stock options would be attractive to you as an employee when you perceive that the value of the company and its stock price will rise significantly from when you were granted the options to when they vest and become exercisable. Employees of start-ups are often willing to bet on the company in hopes that within a few years the company stock can be purchased (for the strike price) at well below the stock’s then fair market value.

What are the Common Types of Stock Options?

There are two primary types of employee stock options and they differ in a few meaningful ways. The less common type is an Incentive Stock Option (ISO). The other, more commonly granted, is a Non-qualified Stock Option (NSO). The important difference between the two types of options centers on the tax treatment of each upon exercise of the options and ultimate sale of the shares. Given the disparate tax treatment of the two types, it is important that you know which type you have. And because the tax implications can be so significant and the consequences of making poor decisions so impactful, it is highly recommended that you consult with a tax expert before exercising any stock option.

Incentive Stock Options (ISOs)

With ISOs, in most cases, if certain conditions are met, you do not have to pay taxes when the option is exercised. Taxes are not owing until the shares are sold and the difference between the strike price and the sale price is taxed as a long-term capital gain (at a lesser tax rate than ordinary income). To qualify for this special tax treatment under the Internal Revenue Code, you must hold the ISO stock for at least two years from the grant date and one year after the exercise of the option.

There are, however, instances where the alternative minimum tax (AMT) may come into play when ISOs are exercised but the shares are not sold within the same calendar year. The AMT is calculated on the difference between the fair market value of the shares on the exercise date and the strike price. This is because the “phantom gains” that come from exercising the ISOs count toward the AMT calculation, but not regular income tax, and taxpayers must pay either their regular tax bill or AMT, whichever is higher. Many employees who have never been subject to AMT, find themselves faced with it in years where they exercise a large number of ISOs. There are strategies to avoid triggering AMT, including calculating how many options can be exercised in a particular year before hitting the “crossover point” where AMT is owing, but those strategies are very fact specific and beyond the scope of this article.

Other features of ISOs are that they may only be granted to employees and not directors, consultants, or contractors. There is a $100,000 limit on the aggregate grant value of the ISOs that may vest in any calendar year. To retain the special tax benefits after leaving the company, the ISOs must be executed with three months of you leaving the company. Finally, ISOs which qualify for the special tax treatment are not subject to Social Security, Medicare or withholding taxes.

Non-qualified Stock Options (NSOs)

NSOs do not qualify for special favorable tax treatment under the Internal Revenue Code. The most significant difference between NSOs and ISOs is that when NSOs are exercised, ordinary income taxes are owed on any gains. The tax applies to the difference between the strike price and the fair market value on the date of exercise. Upon exercise, employers must withhold income taxes, Social Security and Medicare. Capital gains are also owed on any increase in value from when the stock is purchased until it is sold. Unlike ISOs, which may only be granted to employees, NSOs may also be granted to directors, contractors, and consultants.

One advantage to NSOs over ISOs is that NSOs, if the employer’s plan allows it, may be used for gifting purposes as part of your estate plan. Unrestricted transferability is rarely allowed, but many plans allow for transfers to family members and trusts for the benefit of family members. This allows the recipient of the gift to benefit from the future appreciation in the stock value and removes the appreciation from your potentially taxable estate. This feature may become more important if the estate and gift tax basic exclusion is cut in half as is currently slated to happen at the end of 2025.

Considerations in Exercising Options and Selling Stock

Once options are fully vested there are several options on what to do with them. The first option may be to simply hold on to them. However, you can’t hold on to them forever. Options have an expiration date (often 10 years from the grant date) and if your options pass their expiration date, they will become worthless. Reasons to hold the options past their vesting date may be because you think the share price will continue to increase or you may not want to realize additional income in a particular tax year.

However, should you choose to exercise the options, there a few ways to do so. How you choose to do so will depend on your own situation and some of the other considerations outlined below.

Exercise and Hold (cash-for stock)

You can exercise your stock options to buy the underlying shares and then hold the stock.

Exercise and Sell to Cover

You can exercise your option to buy shares and then sell just enough to cover the stock option cost, taxes and transaction fees. The proceeds you will receive will be the company shares.

Exercise and Sell (cashless)

If your broker allows it, you can exercise your option to buy the shares and sell the shares at the same time without using any out-of-pocket cash.

Private vs. Public

If your company is privately owned, there may be additional considerations. Shares of private companies are often difficult to sell as there is often no ready market for them as there is with publicly held companies. You have the risk of holding illiquid shares for a lengthy period of time waiting on an initial public offering (IPO) or other liquidity event.

Your Goals and Objectives

Whether or not to exercise your options and sell shares at a particular time should be largely driven by your financial goals and objectives. If you have an immediate need for cash or you are overly exposed to the risks inherent in holding a large concentration of stock in a single company, it might make sense for you to exercise your options and sell some of your stock before you otherwise might have.

Tax Considerations

As discussed above, there are different tax implications in exercising options and selling the underlying stock depending on the type of options you have. For both NSOs, and those ISOs which do not qualify for the more favorable tax treatment, the gain between the strike price and the fair market value at exercise is taxable as ordinary income. If the additional income from the exercise of the options would push you into a higher tax bracket, you may want to delay the exercise or choose to exercise the options and spread the tax burden over a few tax years.

At Greenleaf Trust, our Trust Relationship Officers, Wealth Management Advisors and Wealth Strategists have many years of collective experience in advising executives on compensation matters as part of a broader and comprehensive holistic wealth management plan. If you would like to discuss how we might be of assistance to you, please let us know. As always, we are here to help.