Making sense of stock options

Health insurance, paid vacation, and company-sponsored retirement plans are all common elements of a typical employee benefits package. But, in addition to these traditional elements, many employers also offer stock options as an extra incentive for select employees.

While stock options can be one of the most valuable perks a company can give you, options can also be difficult to understand. So if you find yourself on the receiving end of this generous benefit, it is important to know how stock options work and what they could mean to you.

In basic terms, stock options give you the right to purchase company stock at a certain price some time in the future. Companies typically use options as long-term incentives for valued employees because the benefit of the option is tied to the success of the company. Giving employees an ownership stake in the company further encourages them to be personally committed to the success of the organization.

As you can probably see already, a stock option gains value as the stock price appreciates. By exercising your option, you purchase stock directly from the company at the option price, which is set when the option is granted to you. One thing to keep in mind: you must exercise your options within a certain period, or they will expire.

There are two more common types of options companies grant: incentive stock options (ISOs) and nonqualified stock options (NSOs).

Incentive stock options (ISOs)

An incentive stock option provides the benefit of a stock price increase as a long-term capital gain if the option meets certain requirements. ISOs must be granted at a price that equals the stock’s market value at the time, so the stock’s price must increase for one to benefit.

In addition, you must meet a minimum holding period requirement for long-term capital gains treatment. One must retain the stock for the longer of: 1) two years from the date of grant and 2) one year from the date of exercise.

When an ISO is granted, no taxes are incurred because there is no transfer of property at grant date. The option price that is paid becomes the cost basis in the stock.

Regardless of whether the stock is sold now or later, the difference between the sale price and the cost basis (option price) is the amount of income that is taken into consideration for taxes. As long as the stock is held for the required holding period, the entire difference between the sale price and the cost basis is long-term capital gain and will receive favorable tax treatment.

If the stock is held for more than one year, long-term capital gain is realized upon exercise of the ISO and the sale of the underlying stock is subject to a 15% maximum tax rate. Individuals in the 10% and 15% tax brackets pay a 5% maximum tax on long-term gains.

If the shares are sold before one year has passed from the date of exercise, the ISO shares are “disqualified.” That is, the shares are treated as if they were purchased with nonqualified options.

The difference between the fair market value at the time of exercise and the option price will be taxed at ordinary income tax rates (possibly as high as 35%), and the fair market value at the time of exercise will become the cost basis in the newly acquired shares. Any difference between the selling price and the new cost basis is considered a short-term capital gain or loss. Generally, short-term capital gains are taxed at the same rate as your ordinary income.

While exercising an ISO does not result in taxable income, the spread between the option price and the stock’s fair market value at the time of exercise is a preference item for alternative minimum tax (AMT) purposes. If the option is disqualified, the preference amount will generally no longer apply. If the ISO grants are large, careful planning is required to limit AMT exposure and to avoid stacking up too many options to be exercised in any one year.

Nonqualified stock options (NSOs)

As with an ISO, there is no taxable event when a company grants an NSO (no transfer of property takes place on grant date). However, when an NSO is exercised, ordinary taxable income equal to the spread between the fair market value of the stock on the exercise date and the exercise price, must always be recognized.

In addition, because the income will typically be considered compensation paid to you, it will be included on the W-2, and employment taxes will apply. The cost basis of the stock acquired through NSO exercises is the fair market value on the exercise date. For this reason, if the stock purchased through the NSO is sold immediately, no additional gain or loss will be recognized if the price of the stock stays the same.

If, on the other hand, the NSO is exercised and the stock is held for some time, a capital gain or loss equal to the difference between the cost basis (fair market value on the date the NSO is exercised) and the price at which the stock is sold, is recognized.

If the stock is sold within one year of the exercise date, the gain or loss will be characterized as short term. If the shares are held longer than one year from exercise date, a long-term capital gain or loss will result.

If you are looking to diversify or generate cash, focus on exercising at a favorable stock price. Consider setting price targets and gradually selling as the stock appreciates.

If your goal is to exercise and hold the stock in your portfolio, consider the risk of a concentrated position in one stock and focus on exercising during stock price declines in order to lower your tax exposure.

Differentiating between the two types of options and their tax consequences is an important first step in understanding stock option benefits. If you receive options from your company as part of your benefits package, you’ll want to be prepared to take full advantage of them.

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