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  • Writer's pictureMalissa Marshall, CFP®, MS Tax, EA

Your Guide to Understanding Stock Options: An Owner's Manual

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The beginning of the year is the perfect time to revisit the plan you have for your stock options – or create one in the first place. 


Whether you’re at a pre-IPO start-up, a growing public company, or a long-standing blue chip, stock options – when wielded effectively – can provide a significant boost to both your short-term cash flow and long-term wealth.


The planning options are relatively straightforward, but you may have realized that the devil is in the details – and it’s very possible that this has kept you from taking action altogether.  Maximizing your profit is just one side of the equation – taxes are also a consideration, and the rules are complex; moreover, the dramatic fluctuations that exercising and selling options can cause in your cash flow may make you seasick unless you plan far ahead.  The intention of this blog post is to offer a basic framework for a plan that you feel confident executing.


Stock Options: the Basics


When you receive a grant of stock options, you receive the right (but not the obligation) to purchase shares of company stock at a certain price within a future window – which will preferably be far below market value when you’re ready to exercise them, so that you receive the maximum possible value from the award.  And, if you continue to hold the shares after exercise, the value of the shares may continue to rise, allowing you to lock in an additional long-term capital gain upon sale. 


Before you can exercise the options, however, the award must first vest, meaning you have to work for the company for a certain period of time in order to be eligible to receive the shares.  The specific vesting schedule will be outlined in your award letter, and may roll out over multiple years.  For example, a common vesting schedule is a one year cliff, with the remainder vesting quarterly over four years.  Translation:  in one year, 25% will vest, then 6.25% will continue to vest each subsequent quarter.  As you can see, when you receive multiple awards, the awards themselves can be more difficult to keep track of.


In some instances, you may be able to exercise your options early, i.e., before they vest, if the plan allows; this is generally more likely in companies that are still pre-IPO.  That move can have tax advantages, but there are downsides as well – it’s a far riskier proposition.  Moreover, it could be a cash flow challenge if you’re prohibited from selling shares to fund the purchase and pay the resulting tax liability, and you have to fund those costs out of pocket.


When you exercise your stock options, you purchase shares of your employer’s common stock at the price indicated in your option grant (the “strike” or exercise price).  The difference between the strike price and the shares' value when you exercise the options is taxable to you – either at your marginal regular income tax rate, similar to your compensation, for non-qualified stock options (NQSOs), or is an adjustment for alternative minimum tax (AMT) purposes for your incentive stock options (ISOs).  


The short answer is: exercising options can be costly, but not prohibitively so, and mostly just require some solid planning with the guidance of a competent professional.


Key Questions


How do I exercise my stock options?


Exercising stock options means buying shares of your employer’s common stock at the price specified in your option grant. Your company will likely have an agreement with a particular brokerage company to execute these stock purchases; once you’ve exercised the options and own actual shares, you can decide whether it makes sense for you to sell immediately or hold onto them for the longer term. Again, option awards give you the right but not the obligation to exercise them – however, you could be leaving a lot of money on the table by not doing so, or by not planning ahead.


How much time do I have?


If your company does not offer early exercising, you can only exercise options once they are vested, which varies from company to company.  Generally, you have 10 years after the grant date to exercise them, or 5 years if you have a significant ownership stake in the company, but the details should be specified in your award letter and/or in the company’s stock plan document.


What should I consider when deciding when to exercise?


Are the options in-the-money or underwater?  If they are underwater (trading below your exercise price), you should wait for the stock price to rise – there’s no value in exercising at a $12 strike price if you can purchase shares directly on the open market for $10.


Is your company public? If your company is still held privately and does not have plans for filing an IPO in the near term, exercising your options may be risky because you are purchasing shares that may not become liquid any time soon, i.e. eligible to be sold.  This means that you’ll be paying for the shares out of pocket, without any way to dispose of them if the company’s fortunes decline. 


Will you have to pay taxes? Depending on your situation (what kind of options you have, the number you were granted, your overall compensation, etc.), it is likely that you will have to pay taxes when you exercise.  Again, the amount and type of taxes (ordinary or AMT) should best be known, and the cash flow hit should be planned for in advance.  Since you won’t be able to sell those shares to pay the tax bill when it comes due (which could be sooner than you’d like if you’re required to make quarterly estimated tax payments – or face an 8%+ underpayment penalty).


When should I sell my shares?


Once you’ve exercised your options, you may want to consult with a financial and tax advisor to discuss the best time to sell the stock.  The type of options you have and how long you hold them after exercising your options will significantly impact your tax liability – again, the best practice is to have a plan and prepare well in advance. 


What do I need to know about Non-Qualified Stock Options (NQSOs)?


NQSOs are the most common type of stock options. Most companies typically choose to grant non-qualified stock options for tax reasons: they can deduct the costs of NQSOs as an operating expense sooner than with other options.


From a planning perspective, unexercised NQSOs can be passed to others, i.e., in divorce or as gifts. In addition, the IRS does not limit the total number or value of NQSOs that a company can grant to an employee.


Assuming you make money when you exercise your shares (i.e., your strike price is lower than the current market price – otherwise, why would you exercise?), the difference, or “bargain element,” will be considered ordinary income and will reported on your Form W2 along with your compensation and any bonuses you receive that year. 


After you exercise, you are free to either hold or sell them according to your personal risk tolerance, cash flow needs, and tax optimization strategy.  At this point, they are like any other stock investment and will be subject to tax upon sale, depending on whether they’re held for less than a year (taxed as ordinary income) or more than a year (taxed preferentially as long-term capital gains).


What do I need to know about Incentive Stock Options (ISOs)?


First of all, there are several requirements which limit the value you could expect to receive from ISO awards.  For example, there is a limit on the total value of ISOs that can vest and can be exercised in any calendar year ($100,000) – if the value of your award is higher than that amount, the shares exceeding the $100,000 maximum value will be automatically converted to NQSOs.  In addition, you cannot transfer ISOs to other people like with NQSOs.


For all that, the tax implications can be more valuable – although more challenging to achieve – as long as a strict schedule is adhered to. You’ll need to hold onto the shares for a minimum of two years from the grant date and one year from the exercise date to qualify for the more advantageous long-term capital gains tax treatment.  And if your company is still privately held (pre-IPO), it can take some careful planning to keep lock-up periods in mind.


The most difficult aspect of ISOs to plan for is that their exercise can subject you to the alternative minimum tax (AMT), which could yield a higher tax liability than you would otherwise pay.  The AMT calculation depends on the “bargain element” – the difference between the price you pay for the shares (the strike price) and the fair market value upon exercise.  However, because you can choose when to exercise, you do have some flexibility in avoiding or minimizing AMT, but it requires careful planning in advance.  A financial and tax advisor can help you model out various scenarios to select the optimal one for your situation.


The Bottom Line


Stock options aren’t quite the proverbial “holy grail” of wealth, since the process of effectively harvesting true wealth from them can seem as arduous as a quest. Having a trusted financial and tax advisor to walk you through all the tax implications, timing considerations, cash flow implications, and risk factors can make the journey far safer, and allow you to keep more of the value inherent in your awards.


Want to know more?  Schedule some time today to discuss your questions and goals with an experienced professional who can save you time and help you achieve the best, most tax-efficient outcome with greater confidence!




This work is powered by Advisor I/O under the Terms of Service and may be a derivative of the original.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.


Image by bady abbas

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