What Is a Stock Option?

From: Jack Chapman

A stock option gives you the right to purchase a certain number of shares of stock in your company for a fixed price. It is a contract between you and the company, subject to certain terms and conditions. The options expire on a certain date, meaning that you only have a certain period of time in which to purchase the shares (also known as “exercising” the options). This is usually ten years. Options are also subject to vesting, a process through which you gradually earn a right to purchase the shares, For instance, you might be 20% vested after one year, 40% after two, 60% after three, 80% after four, and 100% after five years. This means that after two years, you would have the right to exercise 40% of the options.

The price at which you can purchase the shares is usually the fair market price at the time of the grant. With a stock option, you decide when to purchase the shares and when to sell. You cannot lose with an option. If the share price never goes over the grant price, you can simply choose not to purchase the shares. The simplest way to purchase the shares is with cash. Most companies also have “cashless” exercise mechanisms that allow you to receive the shares without actually spending cash. The most popular of these are broker-assisted purchases and sales, company loans, and stock swaps.

Taxes and the Two Different Types of Options

The gain that you recognize with a stock option is subject to tax. There are two different types of stock options, each with a different tax treatment.

Nonqualified Stock Options (NSOs)

Nonqualified stock options (NSOs) do not qualify for any special tax treatment from the IRS. There are no legal limits of how many options people can get, nor are there any requirements for how they should be given out. Companies have complete discretion. Different employees, even doing the same job, can get different option packages.

When employees exercise a nonqualified option, they pay ordinary income tax on the spread between the grant price and the price on the date of exercise. That spread is treated like part of your compensation, and you pay the same taxes as if it were part of your regular paycheck. Your company would get a tax deduction for the same amount. This is true whether you actually sell the shares or not.

If you hold onto the shares after exercise, any additional gain between the price at the time of exercise and the price at the time of sale is treated as a capital gain. There are two capital gains tax rates. Short-term capital gains rates are the same as ordinary income tax rates, but long-term capital gains rates are lower than ordinary income tax rates. To receive long-term capital gains treatment, you have to hold onto the stock for at least one year after exercise before sale.

Incentive Stock Options (ISOs)

Incentive stock options are more complicated, but offer the possibility of better tax treatment for employees. When an employee exercises an ISO they do not pay any tax. When they later sell the shares, they will pay capital gains taxes on the entire spread. Companies do not take a tax deduction for ISOs.

In order to qualify for this better tax treatment, ISOs must comply with certain regulations. Most importantly, the employee must hold the shares for at least one year after the date of exercise and two years after the date of grant. The company must also comply with specific rules about how ISOs are granted.

For example, an individual making $110,000 per year exercises 1,000 incentive stock options at $10 per share for stock worth $25. If the shares are held for at least 12 months after exercise, and go up another $5 per share, for a total gain of $20,000, the total amount ($25 - $10) would be subject to capital gains taxes of 20%, or $4,000.

There is another catch. The exercise of an ISO may also subject optionees to something called the alternative minimum tax (AMT). The AMT was enacted to prevent higher-income taxpayers from paying too little tax because they are able to take a variety of tax deductions or exclusions. The AMT requires that taxpayers who may be subject to it calculate their taxes in two ways. First, they figure out how much tax they would owe using the normal tax rules. Then, they add back in to their taxable income certain deductions and exclusions they took when figuring their regular tax and, using this now higher number, calculate the AMT. If the AMT is higher, the taxpayer pays that tax instead.

This explanation is the simplified version of a potentially complex matter. Anyone potentially subject to the AMT should use a tax advisor to make sure everything is done appropriately. If you receive ISOs take care to consider if you are subject to these rules.

With an ISO, it is also important to emphasize that you do not have to meet the holding periods. You only have to meet the holding periods to receive the favorable tax treatment. If you fail to meet the holding period requirements, then the option is just treated like an NSO. This is known as a “disqualifying disposition. You pay ordinary income tax on the spread between the grant price and the price at exercise and then capital gains on the rest. Since you are disqualifying, you are not holding on to the stock for one year, so you also pay short-term capital gains rates.

Jack Chapman is a nationally know job coach and seminar speaker specializing for the last 20 years in salary negotiations and job interviews.

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