As an employee at a tech company, biotech, or startup, there’s a good chance you may be granted stock options. Having a plan for this type of compensation is crucial for maximizing your benefit. Stock options can be complicated. Grant date, vesting, exercise, AMT, adjusted basis, bargain element, and more is enough to make your head spin. In this post, we’ll break down some of the key terms along with best practices to manage your equity compensation.
At a high level, the major advantage of stock options versus purchasing shares of your company stock is the leverage element. A stock option gives you the right to buy shares at a set price during a specified period in time. There is no obligation to purchase. For instance, if your company’s stock is on the decline, you do not have to exercise or buy your company’s stock. You can simply let your options expire. While holding the option, you are protected from that downside risk. Economically, this leverage element makes employee stock options more valuable than holding actual shares.
When dealing with stock options, you may commonly hear these terms:
At the Money. This means the exercise price, the price where you can buy the shares, equals the fair market value.
Out of the Money. This is when the exercise price is greater than the fair market value. You should not exercise these options.
In the Money. This is when the exercise price is less than the fair market value. This means your stock option has a profit called intrinsic value.
Not to be confused with restricted stock and restricted stock units, the two main types of stock options are Nonqualified Stock Options (NQSO) and Incentive Stock Options (ISO). The key difference is that ISOs qualify for favorable tax treatment if certain conditions are met. Also, ISOs are much more complicated. As we’ll explain, they often create a tax timing issue that may trigger the Alternative Minimum Tax (AMT).
Nonqualified Stock Options are plain vanilla employee stock options. You may be granted options over a period of time subject to vesting. That means each year, you will gain ownership of the options. There will typically be no tax due at the grant date. Once you own the options, you may exercise them. You will pay ordinary income tax on the difference between the fair market value and the exercise price. This difference is called the bargain element. Once you exercise, your holding period begins for capital gains. Shares held longer than a year are subject to capital gains while shares held less than a year are subject to short-term capital gains. The basis for calculating this gain is equal to the amount of ordinary income recognized plus the exercise price. This higher basis means you will not be taxed twice on the same amount.
Here’s an example:
You are granted 100 NQSOs at an exercise price of $20 per share. The stock is currently trading at $20 per share.
There is no tax due at the grant date.
A year later the stock is trading at $40 per share. You decide to exercise your options. You will claim $20 per share of ordinary income on the bargain element for a total of $2,000.
If you decide to hold onto the shares and sell in 2 years when the stock is trading at $50, you will have capital gains tax due. You will have an adjusted basis of $40 (bargain element + exercise price) and a $10 long-term capital gain per share ($50-$40).
Incentive Stock Options are a bit different than previously described above. When you exercise an ISO, you actually don’t pay any ordinary income tax. However, the spread between the fair market value (stock market price) and the exercise price creates a positive adjustment for Alternative Minimum Tax (AMT). AMT is an alternative tax calculation that deals with tax timing issues. If your AMT tax liability is higher than your regular tax, then you have to pay the difference on top of your regular tax.
If you hold ISOs for two years from the date they are granted and more than one year from the date of exercise, the entire gain is taxed as a long-term capital gain. Depending on your tax bracket and the number of options granted, this could result in quite a bit of tax savings. In addition, you will also receive an AMT credit for later use. However, be aware that holding out for potentially better tax treatment exposes you to more individual stock risk. In a worst-case scenario, you could still owe AMT even if the stock price has fallen. However, if you decide to exercise and sell in the same calendar year, you will avoid having to deal with AMT. In this case, it would be treated similar to NQSOs in that the bargain element would be taxed as ordinary income.
The toughest decisions to make with stock options is when to exercise and whether to continue holding the stock. There is no guarantee your company’s stock will increase. And, holding a globally diversified portfolio compared to an individual stock is tough to beat.
For NQSOs, selling once you exercise is a common strategy to reduce the company-specific risk of holding shares. This strategy also protects you from potentially losing your profits. Once you own shares, you’ve lost that leverage element of downside protection. As to when to exercise, there is no perfect answer. An option’s entire value is composed of both an intrinsic value and a time value. The intrinsic value is the paper profit aka the amount the market price exceeds the exercise price. The time value is a little more difficult to quantify. It is the amount of time that is left before the options expire. If the stock’s value is much higher than the exercise price, then it is usually a good idea to exercise at least some of your options. If your options don’t expire for another ten years and the exercise price is slightly below the stock’s value, then you may want to hold on to the options to preserve the time value. As to where you draw the line, it depends on your overall financial situation, the percentage of options in relation to your net worth, and your comfort level with risk. There is no perfect formula for determining when to exercise.
For ISOs, the added variable is the tax treatment. Do you continue holding the shares to qualify for the lower long-term capital gains rate or do you exercise sooner? Planning around ISOs requires good record keeping. You must keep track of your AMT amount, AMT credit, basis, and project out your tax liability. Because a calculated strategy is needed, it is best to consult with both a CFP® Pro as well as a qualified tax professional.
Like any investment, a stock option provides an opportunity to build wealth. Your company may explain the mechanics of participating in your option plan, but they can't tell you when to exercise, how long to hold the stock, and what percentage of your overall portfolio should be diversified. The plan that makes sense for you isn't necessarily the optimal plan for someone else. Your choices should be tailored to your own financial goals, investment portfolio, and tax situation.
If you would like guidance from a CERTIFIED FINANCIAL PLANNER™ Professional on how to manage your company's equity plan, reach out to schedule a free consultation.
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