I Received Company Stock Options. Now What?

Receiving stock options is exciting but can also create a lot of questions. First, what is a stock option? A stock option is simply a financial incentive that gives an individual the right, but not the obligation, to buy or sell shares of a company’s stock at a predetermined price. Typically, this is advantageous for employees because they can purchase the company stock at lower prices.

There are few different types of stock options and they each come with their own rules for taking ownership of those stocks and rules surrounding their taxation.

But before we break those down, let’s start with common terms:

Grant Date: This is the date the stock option is given to the recipient and sets the starting point for the vesting schedule (we will break this down below).

Exercise Price (Strike Price): This is the price the recipient can purchase the stock for when they exercise (take control and ownership) their option. This price is set when the option is granted and is typically based on the then fair market value of the stock.

Vesting Schedule:  This is the timeline that the option holder is limited to for exercising their options. This is very important to understand because it becomes the amount of time you need to work for that company before you can exercise your right to purchase the stock.

Expiration Date: This is the last date you can exercise your stock options. If you do not exercise (purchase) your stock options by the expiration date, you forfeit them.

Now that we have some vocabulary out of the way, let’s look at a few types of stock options and how they are treated for tax purposes.

Incentive Stock Option: An ISO must be received by an employee and the exercise price is equal to the fair market value on the exercise date. ISOs come with some favorable tax treatment for recipients. Taxes for these stock options are deferred until the shares are sold and are subject to long-term capital gains taxes, which are often lower than your marginal income tax rate. The catch is you need to hold those shares after exercising them for at least one year (or at least two years after the grant date). If you sell before that time frame you will owe short-term capital gains taxes, which is your marginal income tax rate. The optimal time to exercise these options is usually when the strike price is below the market price for the stock. This allows you to take ownership of the stock and potentially sell it after the one year holding period to make a gain.

Non-Qualified Stock Option:  An NSO can be awarded to an employee or other service providers like contractors and board members. These come with different taxation rules. NSOs are taxed as ordinary income when they are exercised. The taxable amount is the difference between the exercise price and fair market value of the stock at exercise. For example, if you receive an NSO with an exercise price (strike price) of $100 and the value of that stock is $500 in the market, you will owe ordinary income tax on the $400 difference. Once you have taken control of the stock, you will be subject to short-term and long-term capital gains rates depending on how long you hold the stock. Many times, people will sell the stock immediately after exercising it.

Restricted Stock Unit: RSUs are also company shares given to an employee with vesting restrictions similar to the other options discussed in this blog. However, RSUs don’t require the employee to purchase the stock. Instead they receive the shares once certain conditions are met. Conditions are usually based on the employee remaining with a company for a certain period or tied to performance-based metrics. RSUs can be great incentives for attracting and retaining employees.

They are taxed as ordinary income based on the fair market value of the shares at the time they vest. This can be a blessing or a curse. Although you never need to worry about purchasing these shares and can be much simpler to understand, they can create a large tax liability on a timeline you cannot control, depending on how many shares you received and the value of those shares.

Once RSUs vest, the employee has full control over when and how much to sell but you will still be subject to capital gains tax rates.

Stock Appreciation Rights: SARs are an employee inventive plan that provides the right to receive a payment based on the increase of value in a company’s stock. They do not have a purchase requirement, which makes them a cash payout form of compensation. If you decide you would rather have the stock instead of a cash payout, you receive shares in the amount of the appreciation value. Like other stock options, there is a vesting period before employees can exercise the stock, and these are taxed as ordinary income when exercised. SARs can be great because employees do not need to purchase stock and they aligns the employees’ interest with the company’s growth.

Stock options can be a great addition to an employee’s compensation package, especially if you know the taxation and control rules and plan accordingly. We always advise engaging with a tax or financial planning professional to make sure you are maximizing your stock options and prepared for the future tax implications.