Money 101, Financial Education. Lesson # 10 Employee Stock Options

Top things to know

1. Employee stock options are no longer reserved for the executive suite.
From cash-poor Silicon Valley startups to old-line manufacturing and service firms competing for top talent, more and more companies are offering stock options to the rank and file as well.
2. Stock options are still popular.
According to the National Center for Employee Ownership as many as 9 million employees participate in some 3,000 plans. In 1990, only 1 million U.S. employees had them.
3. Stock options can be expensive to exercise.
The lesson of the dot-com crash: Improperly exercising stock options can cause real financial headaches, particularly when it comes to paying taxes on your profits. Even if you keep the stock you purchased, you'll still have to pay taxes. But if you're careful not to overreach, options can be a lucrative benefit.
4. You'll see these common terms:
An employee stock option gives you the right to buy ("exercise") a certain number of shares of your employer's stock at a stated price (the "award," "strike," or "exercise" price) over a certain period of time (the "exercise" period).
5. There are two common types of plans:
Employee stock options come in two basic flavors: nonqualified stock options and qualified, or "incentive," stock options (ISOs). ISOs qualify for special tax treatment. For example, gains may be taxed at capital gains rates instead of higher, ordinary income rates. Incentive options go primarily to upper management, and employees usually get the nonqualified variety.
6. Nonqualified plans are special.
Unlike ISOs, nonqualified stock options can be granted at a discount to the stock's market value. They also are transferable to children and charity, provided your employer permits it.
7. There are three main ways to exercise options:
You can pay cash, swap employer stock you already own or borrow money from a stockbroker while simultaneously selling enough shares to cover your costs.
8. It's usually smart to hold options as long as you can.
Conventional wisdom holds that you should sit on your options until they are about to expire to allow the stock to appreciate and, therefore, maximize your gain. In the aftermath of the tech stock swoon, that logic may need some revision. In any event, you should not exercise options unless you have something better to do with the realized gain.
9. There may be compelling reasons to exercise early.
Among them: You have lost faith in your employer's prospects; you are overweighted on company stock and want to diversify for safety; you want to lock in a low-cost basis for nonqualified options; you want to avoid catapulting into a higher tax bracket by waiting.
10. Tax consequences can be tricky.
Unlike the case with nonqualified options, an ISO spread at exercise is considered a preference item for purposes of calculating the dreaded alternative minimum tax (AMT), increasing taxable income for AMT purposes.

The rise of employee stock options
Employee stock options used to be reserved for the executive suite. No longer. From cash-poor Silicon Valley startups to old-line manufacturing and service firms, more and more companies are offering stock options to the rank and file as well.
The National Center for Employee Ownership (NCEO) estimates that about 9 million Americans hold stock options and that the plans account for at least several hundred billion dollars.
In 1990 there were only about 1 million workers covered by a few hundred stock option plans. Today there are nearly ten times that many employees participating in some 3,000 plans.
Still, management continues to receive the lion's share of stock option grants. Of companies that grant options to more than half their employees, nonmanagement receives 45 percent of total options allocated, on average.
At the largest companies, this average is 29 percent. At biotech and computer firms, however, 55 percent of option grants go to nonmanagers.

The ABCs of ESOs
An employee stock option is the right given to you by your employer to buy ("exercise") a certain number of shares of company stock at a pre-set price (the "grant," "strike" or "exercise" price) over a certain period of time (the "exercise period").
Most options are granted on publicly traded stock, but it is possible for privately held companies to design similar plans using their own pricing methods.
Usually the strike price is equal to the stock's market value at the time the option is granted but not always. It can be lower or higher than that, depending on the type of option. In the case of private company options, the strike price is often based on the price of shares at the company's most recent funding round.
Employees profit if they can sell their stock for more than they paid at exercise. The National Center for Employee Ownership estimates that employees covered by broad-based stock option plans receive an amount equal to between 12 and 20 percent of their salaries from the "spread" between what they pay for their option stock and what they sell it for.
Most stock options have an exercise period of 10 years. This is the maximum amount of time during which the shares may be purchased, or the option "exercised." Restrictions inside this period are prescribed by a "vesting" schedule, which sets the minimum amount of time that must be met before exercise.
With some option grants, all shares vest after just one year. With most, however, some sort of graduated vesting scheme comes into play: For example, 20 percent of the total shares are exercisable after one year, another 20 percent after two years and so on.
This is known as staggered, or "phased," vesting. Most options are fully vested after the third or fourth year, according to a recent survey by consultants Watson Wyatt Worldwide.
Whenever the stock's market value is greater than the option price, the option is said to be "in the money." Conversely, if the market value is less than the option price, the option is said to be "out of the money," or "under water."
During times of stock market volatility, a company may reprice its options, allowing employees to exchange underwater options for ones that are in the money. For example, if options were originally exercisable at $50, and the stock's market price dropped to $30, the company could cancel the first option grant and issue new options exercisable at the new $30 share price.
Does that sound like cheating? Maybe, but it's perfectly legal. Outside investors, however, generally frown upon the practice - after all, they have no repricing opportunity when the value of their own shares drops.

Types of options
Companies can offer different kinds of plans, depending on what they're trying to get out of the offering.
The various plans offer very different tax advantages and disadvantages, both to the company issuing the options and to the employee receiving them. In general, most options fall into one of two categories: nonqualified options or incentive stock options.
Nonqualified stock options
These are the stock options of choice for broad-based plans. Generally, you owe no tax when these options are granted. Rather, you are required to pay ordinary income tax on the difference, or "spread," between the grant price and the stock's market value when you purchase ("exercise") the shares. Companies get to deduct this spread as a compensation expense.
Choosing the right moment to exercise is not as easy as it looks. For example, let's say you were granted an option to buy 1,000 shares at $5 per share. The stock hits $10 in the public market, at which point you cash in because your grant is about to expire. Your exercise price nets you a gain of $5,000 in this example, which you'd claim on your tax returns as ordinary income.
Now, let's say you think the stock is going to go higher, so you hold onto the shares. Sadly, the market crashes, bringing your shares down to $5, at which point you sell. Here's the bad part: you still owe income tax on that $5,000 profit, even though you never turned it into cash.
From the IRS point of view, that gain was income, which you chose to use to make an "investment" in the stock you kept. If you subsequently sold those shares at $5, you will get a $5,000 capital loss to show for your efforts, which will offset your notional gain somewhat but not entirely.
In a happier example, let's say you hold on, and the stock rises. Any subsequent appreciation in the stock is taxed at capital gains rates when you sell. Keep the stock for more than a year, and you'll have a long-term capital gain, taxed at a top rate of 15 percent; hold for one year or less, and your gain is short term, taxed at higher, ordinary income tax rates.
Nonqualified options can be granted at a discount to the stock's market value. They also are "transferable" to children and to charities, provided your company permits it.
A safe way to deal with potential uncertainty in share prices is to take out some cash when you exercise, at least enough to cover the tax bill.
An even more conservative way to deal with stock options is to view them exactly the way the IRS does: as income. When you decide to exercise, take 100 percent of your profits in cash - don't hold onto any shares. Then, manage that money as you see fit.
Incentive stock options
These are also known as "qualified" stock options because they qualify to receive special tax treatment. No income tax is due at grant or exercise. Rather, the tax is deferred until you sell the stock.
At that point, the entire option gain (the initial spread at exercise plus any subsequent appreciation) is taxed at long-term capital gains rates, provided you sell at least two years after the option is granted and at least one year after you exercise.
ISOs give employers no tax advantages and so generally are reserved as perks for the top brass, who tend to benefit more than workers in lower income tax brackets from the capital gains tax treatment of ISOs.
High-paid workers are also more likely than low-paid workers to have cash to buy the shares at exercise and ride out the lengthy holding period between exercise and sale.
If you don't meet the holding-period requirements, the sale is ruled a "disqualifying disposition," and you are taxed as if you had held nonqualified options. The spread at exercise is taxed as ordinary income, and only the subsequent appreciation is taxed as capital gain.
Unlike nonqualified options, ISOs may not be granted at a discount to the stock's market value, and they are not transferable, other than by will.
Two warnings apply here:
1. No more than $100,000 in ISOs can become exercisable in any year.
2. The spread at exercise is considered a preference item for purposes of calculating the dreaded alternative minimum tax (AMT), increasing taxable income for AMT purposes. A disqualifying disposition can help you avoid this tax.

Exercising stock options
Many employees rush to cash in their stock options as soon as they can. That's not always so smart.

There are three basic ways to exercise options: pay cash, swap company stock you already own, or engage in a "cashless exercise."
Cash exercise
This is the most straightforward route. You give your employer the necessary money and get stock certificates in return. What if, when it comes time to exercise, you don't have enough cash on hand to buy the option shares and pay any resulting tax?
Stock swaps
Some employers let you trade company stock you already own to acquire option stock. Say your company stock sells for $50 a share, and you have an ISO to buy 5,000 additional shares for $25 each.
Instead of paying $125,000 in cash to exercise the option, you could exchange 2,500 shares (with a total market value of $125,000) you already own for the 5,000 new shares. This strategy has the additional benefit of limiting your concentration in company stock (see below). Note: You must have held the swapped ISO shares for the required one- and two-year holding periods to avoid having the exchange treated as a sale and thus incurring tax.
Cashless exercises
This is a case in which you borrow from a stockbroker the money needed to exercise your option and, simultaneously, sell at least enough shares to cover your costs, including taxes and broker's commissions. Any balance is paid to you in cash or stock.
When to exercise
Although conventional wisdom holds that you should sit on your options until they are about to expire to allow the stock to appreciate and therefore maximize your gain, many employees can't stand to wait that long. One pre-bear-market study found that the typical employee cashed out of options within six months of becoming eligible to do so, thereby sacrificing an estimated $1 in future value for every $2 realized.
There are many legitimate reasons to exercise early. Among them:
1. You have lost faith in your employer's prospects and therefore in its stock.
2. You are overdosing on company shares. (It is generally imprudent to keep more than 10 percent of your portfolio in employer stock.)
3. You want to avoid getting pushed into a higher tax bracket. Waiting to exercise all your options at once could do just that. Exercising a portion at a time can alleviate the problem.
During the tech stock bubble, for example, at least a few conservative employees took profits in their high-flying companies' shares. Turning paper gains in options into real cash - despite exercising "early" according to conventional wisdom - seems to have been extraordinarily prudent in retrospect.
A quick way to estimate the value of your options is to calculate how much you would pocket after exercising them and immediately selling the shares. (Remember also that income tax will be due on that gain.)
You may be tempted to lock in a low-cost basis for your nonqualified options. Since the spread at exercise is taxed as ordinary income, it might make sense to exercise early so you can take most of your earnings in stock appreciation, taxed at lower, capital gains rates. This assumes, however, that you expect the price of the stock to continue rising in the future.
It's vital to remember that when you hold onto shares that have been converted from exercised options, it is the same as making an investment in the stock. Any time you hold stock - regardless of the method by which you acquire that equity - it carries the same potential risk. If you're not comfortable with the possibility of a decline, don't hold onto the shares.