How Do Employee Stock Options Work?

Employee Stock Options

Employee stock options (or ESO’s) have long been a means to lure senior executives to corporations.  However, more and more companies are granting these options to rank and file employees as well.  As a result, the question, “How do employee stock options work?” is coming up more and more frequently in the online financial discussion boards that I follow.

What is an Employee Stock Option Anyway?

An employee stock option is a contract issued by an employer to an employee to purchase a set amount of shares of company stock at a fixed price for a limited period of time.  Usually, this fixed price is set a little lower (typically 10-15%) than the current price of the stock.

So, let’s say your company’s stock is currently trading at $10 per share.  Your employer may grant you an ESO contract to buy 1,000 shares at $9 per share.  You’re super-happy about this because what normally would cost you $10,000 (1,000 shares x $10 per share) now only costs you $9,000 to buy.

Not So Fast, Partner

One of the great things about employee stock options is that you do not need to exercise them right away.  In fact, many employers do not allow employees to exercise the options immediately, but instead give employees the ability to buy the discounted shares on a vesting schedule.

Continuing along with our example above, let’s say your employer grants you the 1,000 share employee stock option on March 1st, 2016.  Then, a year from that date, 200 of the shares will “vest” and the employee can now buy 200 out of the 1,000 shares at the $9 strike price.  Vesting continues on this schedule at a pace of 200 shares per year until the employee is vested in all 1,000 shares by March 1st, 2021.

How Will My Options Be Taxed?

There are a couple of factors at play here.  Let’s assume for this example that you have been granted non-qualified stock options. Although still great in many ways, these options are not offered special tax treatment by the federal government.

The grant date is not a taxable event, but the exercise date is.  Here, Uncle Sam is looking at the “bargain element” or just how much of a discount you are getting on those company shares and treating it as compensation that is taxable at ordinary income rates.

Going back once again to our previous example, let’s say you patiently waited to be fully vested in all 1,000 of your shares and the stock is now worth $19 per share.  The bargain element of the transaction is $19 – your $9 strike price or $10 per share x 1,000 shares or a total of $10,000.  This $10,000 will be treated as ordinary taxable income.

It gets even trickier from here.  Now let’s suppose your company stock rises over the next six months to $25 per share and you decide to sell.  You’ve just triggered another taxable event and this short-term gain ($25 – $19) x 1,000 or $6,000 will once again be taxed at ordinary income rates.

You are often better off waiting at least a full year after exercising your options to sell them.  If you do, any profit you make will be taxed at the lower long-term capital gains rates.

What if I have Incentive Stock Options?

Incentive stock options are an even better deal for employees because they do get special tax treatment.

First, no taxable event occurs at exercise.  However, in some cases, the bargain element may trigger the Alternative Minimum Tax (AMT), and I recommend working with a qualified tax professional to manage through this scenario.

When you eventually do decide to sell the shares, the event will be taxed at the lower long-term capital gains rates provided that you hold the shares at least 12 months from the exercise date and a full 24 months from the grant date.

Your Assignment

If you have been granted employee stock options, it’s important for you to do some up front planning.  Be sure to have enough cash on hand to be able to exercise the options and hold them for at least a year to capture the favorable long-term capital gains tax treatment.

You’ll be handsomely rewarded for doing this planning work to make the most of this fantastic employee benefit!