Congratulations–you’ve got options! You now have an increased stake in the place you work.
However, you also have tax issues, and it’s important to understand those issues before you exercise options or make any other decisions regarding your stock options.
What Kind of Employee Stock Options Did You Receive?
The first thing you need to know is whether your options are non-qualified stock options (NSO) or incentive stock options (ISO). Your employer can tell you which kind you have.
Non-Qualified Stock Options
Unless you are in upper management, chances are you received non-qualified stock options. Don’t worry, “non-qualified” is not as bad as it sounds. It only means you don’t get all the breaks recipients of incentive stock options do. You still don’t have to worry about paying tax when you initially receive the options or when they are vested (when the options are actually yours).
Exercising non-qualified stock options can cost you money, however, at least in the short run. Stock options have a set price at which you can buy stock, called a “strike price.” Say your strike price is $1 per share, and you wait until the stock is $1.50 per share before you exercise your options and buy 100 shares at $1 each. You’ll pay ordinary income tax on the difference between strike price and market value ($1.50 – $1.00 = .50). On 100 shares, that’s income of $50.
Here’s the catch: If you don’t have enough money from other sources to pay tax on the $50 bargain element from exercising your stock options, you may have to sell some of your stock. If you have not held the stock for one year since you exercised the option when you sell it, you then have to pay short-term capital gains rates on any gain from the sale of the stock.
On the other hand, if you can hang on to the stock you bought by exercising your options for more than one year, you’ll qualify for long-term capital gain rates on any profit from the sale.
Incentive Stock Options
Incentive stock options (ISOs) get preferential treatment by the IRS. You do not owe taxes when you receive incentive stock options, just the same as if you had received non-qualified options. However, when you exercise incentive stock options, you still don’t pay tax, either–even if when you exercise your options the stock is worth far, far more than your strike price. Only when you sell the stocks do you pay tax.
Maximizing Your Company Stock Options
You don’t have much say over how many stock options you receive or what type. To make the most of your company stock options, follow these rules:
- If you have non-qualified stock options, avoid exercising more options at one time than you will be able to pay taxes on from other funds if you don’t want to owe short-term capital gains tax on stock you sell.
- Plan to hold stocks longer than one year before you sell them at a gain.
- If you’re selling stock at a loss, match the sale to a year in which you have other capital gains you can use to offset the loss, if possible.
- Always make stock buying and selling decisions based primarily on what you consider to be the best investment decision, then on preferential tax treatment. There are worse things than owing taxes, like losing money because your stock went down before you sold it.
A holder of employee stock options should avoid making early exercises of his/her options because that causes an forfeiture of part of the options value back to the issuing employer. It also causes an early tax on the intrinsic value (i.e. the amount that the stock is above the exercise price when the options are exercises). If a person is fortunate enough to have a substantial gain on his ESOs, he/she can reduce the risk and take profits by hedging with exchange traded calls and puts, without a forfeit of any part of the value of the options and delaying the taxes to expiration of the options. He may even be able to turn the gain on the ESOs into tax free income, with proper advice.
John Olagues