Stock options or awards can be quite complex. The goal of Employee Stock Options Explained is to provide employees with a complete primer to their stock options. Simple explanations so you have the tools to begin to manage your stock options. Employer stock may be a significant part of your net worth, which is why it’s so important to partner with professionals who can help you make the right decisions for your individual situation and goals.
Stock Options Explained
To maximize the benefit of stock options or awards, you’ll need to have an integrated strategy that can help you diversify your investments, while taking into account the tax implications and other financial planning considerations.
Understanding your employee stock options or equity awards
Key employee stock option terminology
Throughout this article we will be using a number of terms to explain how stock options and equity awards work:
- Exercise price (or the strike price). The exercise price is the price you’re able to buy the shares. This price is set in advance and doesn’t change.
- Fair market value (or FMV). Fair market value is the price of a share of company stock in the open market. If publicly traded, the price on a public stock exchange. If the company is private, a valuation firm will periodically conduct a FMV analysis. The fair market value of public company stock changes all the time.
- In-the-money. When a stock option is “in-the-money” or “above water” the strike price is less than the fair market value of the shares. Here’s an example: if your exercise price is $5 and the stock is trading for $10, it’s “in-the-money.”
- Out-of-the-money. When a stock option is “out-of-the-money” or “underwater,” the strike price is more than the fair market value of the shares. Using the previous example, if the stock was trading for $4 not $10, it would be “underwater”.
- Vesting schedule. A vesting schedule is provided along with your stock option or equity award agreement. It provides key dates for exercising, vesting, strike price, and number of shares in the grant. Vesting is so important. It dictates when you earn the right to buy the stock or receive shares.
What type of employee stock options do you have?
Companies grant two kinds of stock options:
- Nonqualified Stock Options (NQSOs) are the most common type of stock option. When you exercise in-the-money stock options, the difference between the exercise price and the market value is going to be taxable W-2 income to you, at ordinary income tax levels plus Social Security and Medicare taxes.
- Incentive Stock Options (ISOs) offer tax benefits: after you exercise the options, if you hold the stock for at least two years from the date of grant and one year from the date of exercise, you receive favorable long-term capital gains tax treatment for all appreciation over the exercise price. But caution! Don’t overlook the significant tax impact that ISO exercises and sales may have upon calculations of alternative minimum tax (AMT); failure to plan for this can result in a shock come tax-time.
Restricted stock units (RSUs) aren’t stock options – they’re equity awards
The difference isn’t just semantics either. Unlike stock options – which require the employee to purchase the option at the strike price – restricted stock units are just given to employees as equity awards, typically upon vesting. So unlike stock options which can become “underwater” if the market price is less than your purchase price, RSUs always have some value unless the stock goes to zero. Obviously, at that point, you would have other issues to contend with.
At grant, RSUs have no tax or income implications as they are still considered “unearned.” To earn the shares, employees must meet vesting requirements set forth by the employer. Many public companies will require time-based vesting but could also include other performance-related requirements, like reaching a target stock price.
Private companies typically have a time-based vesting requirement in conjunction with an event-based requirement, such as an IPO, funding, or an acquisition for liquidity. When RSUs vest they become common stock. The value of your equity grant will be determined by the current market value on the vesting date.
Restricted stock awards (RSAs) are another common type of equity-based compensation
A restricted stock award is a type of stock compensation plan where employees or executives are granted (or may purchase) a specified number of shares of company stock (or cash equivalent) to be received at a later date, after vesting requirements are met.
For restricted stock awards to yield any value, employees must first satisfy the vesting requirements, which may be time or performance based. RSAs allow employees to make a choice about when to pay income tax on the award – called an 83(b) tax election. Although very similar to restricted stock units, restricted stock awards are not the same thing.
How are stock options taxed?
Tax treatment of incentive stock options (ISOs)
As mentioned earlier, holding ISOs through the end of the calendar year in which you exercised the options can often trigger the alternative minimum tax (AMT). Further, your employer is not required to withhold any amount at exercise or sale to cover your potential income tax liability.
So although incentive stock options do have tax benefits if you satisfy the holding period requirements (at least two years from the date of grant and one year from the date of exercise), in many situations it still may not be advantageous to do so. The AMT and the risk the options may become underwater are two driving factors. This infographic has more on the taxation of incentive stock options.
Taxation of non-qualified stock options (NQSOs)
Although NQSOs don’t offer any tax benefits, the tax treatment is more straightforward. Also, your employer will withhold some funds for federal income tax purposes. However, this in no way means the automatic withholding is sufficient. Assuming they are not underwater, non-qualified stock options will be taxed at both ordinary income rates and either short-term or long-term capital gains tax rates. This infographic has more on the taxation of non-qualified stock options.
Tax treatment of restricted stock units (RSUs)
When vesting occurs for U.S. employees, the value of the stock grant is considered ordinary income for tax purposes. Ordinary income (or W-2 income) is subject to federal, state, and local taxes in addition to Medicare and Social Security (up to the maximum; $142,800 in 2021).
Although many employers will automatically withhold a portion of income to cover some of the tax due some additional tax planning may be required, as the amount may not be sufficient depending on your situation. It is advisable to consider consulting a CPA or other tax professional to determine whether a quarterly tax payment is required to avoid underfunding your tax liability.
Taxation of restricted stock
The tax treatment of restricted stock awards is one of the more unique features of this type of equity compensation. Individuals have some say in how their RSA is taxed through the choice to either make an 83(b) tax election or take no action and proceed with the default tax method.
Default taxation of restricted stock awards
No tax is due when the grant is accepted. At vesting, the difference between the fair market value and the amount you paid for the shares is ordinary income. If you sell the shares immediately, there are no other tax consequences. If you hold the stock, any further gain or loss after vesting is considered a capital gain or loss when you sell the shares.
Whether you’ll have a taxable capital gain or loss depends on your holding period. More than one year is long-term, anything less is short-term. Short-term capital gains rates are essentially the same as regular income.
83(b) tax election
An 83(b) tax election allows restricted stock award recipients to pay ordinary income tax on the award before it vests. The portion of ordinary income is the difference between the fair market value of the stock at grant and what you pay for the shares. Any additional gain or loss after the shares vest is a long-term capital gain or loss. You’ll pay the tax in the year you sell the stock. This article has more on restricted stock.
Other ways employees own company stock
- Employee stock purchase plan (ESPP): Section 423 employee stock purchase plans allow you to buy shares of your company’s stock, typically at a reduction of 5% to 15% compared to the market price. ESPP accounts will withhold a portion of pay through regular payroll deductions, up to $25,000 per year. The ESPP plan buys the stock a few times a year, semi-annually or quarterly usually.
- Employer stock in your retirement plan: According to Bloomberg’s ranking of retirement plans, in 2014, one in five of the largest companies in the S&P 500 made 401(k) contributions in company stock. Owning too much company stock in always a risk. But when the shares are in your retirement plan, it can have devastating effects. While you can’t control whether your employer matches in cash or stock, you can control the asset allocation for your contributions. In the right situations though, there can be tax benefits to holding company stock in your 401(k): net unrealized appreciation.
Can you have too much company stock?
In a word: yes. And most people do. How much you should invest in employee stock options and company stock depends on your assets and risk tolerance. In general, don’t tie up more than 10% of your net worth in your employer’s stock.
Holding too much of any one stock is a risk; and it is a risk that many investors actually choose to take, whether they intend to or not. This article has more on why putting too many eggs in one basket and over-investing in company stock can be a bad idea.
Managing concentrated stock positions and how to diversify
How to diversify out of a concentrated stock position depends on your individual situation. But in general terms, there are several ways employees can reduce their concentration in employer stock:
- If your compensation package is too heavily weighted in stock options or restricted stock units, try to renegotiate. Perhaps you can restructure a deal that is more balanced.
- If your employer matches retirement plan contributions in shares of company stock, you may be able to diversify right away. Most companies who match only in employer stock allow sales immediately. Read your retirement plan documents for more information.
- If you’re receiving stock options or RSUs, you may reconsider participating in an employee stock purchase plan. You can’t control your grants, but buying shares in an ESPP is optional.
- If your company stock is a big part of your compensation and net worth, consider working with a financial advisor and CPA to develop a plan to systematically liquidate and diversify your positions. This doesn’t always mean selling everything, either. By developing a systematic diversification strategy integrated with your entire financial life, you can help ensure you’re making the most of your stock options. Advisors can help keep an eye on potential tax consequences and your overall risk exposure.
- Whether your shares are vested and whether or not you’ve exercised
- What type of equity compensation you have? (e.g. stock options, restricted stock units, employee stock purchase plan, stock appreciation rights, phantom stock)
- Whether your employer is public or private – or a public company that later goes private
- Why you’re leaving the company (retirement, a new job, laid off, terminated with/without cause)
- What (if any) specific terms you negotiated with the company
Termination for cause will typically result in cancelling vested or unvested options that haven’t been exercised. But if you leave for another reason, you may still be able to exercise your vested options. In most plans, RSUs, and stock appreciation rights (SARs) shares of stock or settled in cash upon vesting.
If you leave before vesting, you will likely lose your equity compensation. This article has more on what happens to your stock options when you leave the company.
What it means for your stock options if your company is bought by another firm
Unfortunately, there is really no concrete answer for this question. What can happen will be determined by a number of factors: for example, are your options vested or unvested? Have you exercised the options? Is your company public? Is your company selling to a private firm?
You will probably have to wait until the terms of the M&A agreement are released, but in the interim, read your stock option agreement. There should be some language in there about what may happen in the event of a merger or acquisition. More in this article on what happens to stock options after a company is sold or merges.
What happens to restricted stock units or awards after an acquisition?
What can happen to restricted stock units after a company sells or merges will depend on several factors. It isn’t always about money either. If the acquiring firm doesn’t give current employees stock options, it may not want to.
The terms of the deal play a large role too. Is your company is being sold in an all cash deal, all stock, or blend of the two?
Managing stock options can be difficult, especially with a busy schedule. When developing a strategy for your equity compensation, make sure it is integrated with the rest of your investment strategy. Financial planning can’t happen in a vacuum! If you need help or want to speak with an advisor about your personal situation, please contact us today.