Should I Buy Stock Options in My Company?
Considering company stock options? Understand the financial factors, tax implications, and practical steps to make an informed decision about your employee equity.
Company stock options offer employees a direct financial stake in their employer’s success. Deciding whether to exercise these options requires understanding their mechanics, tax implications, and alignment with personal financial goals. Careful consideration helps maximize potential benefits and manage risks.
Understanding Company Stock Options
Company stock options give an employee the right, but not the obligation, to purchase a specified number of company shares at a predetermined grant or strike price. This price is set when the options are awarded. Unlike Restricted Stock Units (RSUs), options require the employee to buy the shares.
Options typically have a vesting schedule, meaning ownership rights are gained over time. For example, a four-year schedule with a one-year cliff means no options vest until the first anniversary, then a portion vests, and the rest vests monthly or quarterly. Options also have an expiration date, usually ten years from the grant date, after which they become worthless.
Two main types of stock options exist: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs are often granted to employees and receive favorable tax treatment if specific holding periods are met. NSOs are more flexible, extending to consultants or board members.
Neither ISOs nor NSOs are taxed when initially awarded. However, their tax treatment differs significantly at exercise.
Exercising Company Stock Options
Exercising company stock options means purchasing shares at the grant price. This decision depends on the stock’s current market value relative to the grant price. If the market price is higher, the options are “in-the-money” and hold value.
A cash exercise involves using personal funds to pay for the shares. This requires sufficient liquidity. Once paid, the employee owns the shares, which can then be held or sold.
A cashless exercise allows acquiring shares without personal capital. A firm facilitates the simultaneous exercise and sale of a portion of shares. Proceeds from this sale cover the exercise price and taxes, with remaining shares delivered to the employee.
The sell-to-cover method is a variation where enough shares are sold upon exercise to cover the exercise price and tax withholding. The remaining shares are then deposited into the employee’s account.
Taxation of Company Stock Options
Tax implications for company stock options vary significantly between Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). For NSOs, there is no tax event at grant. Upon exercise, the “bargain element”—the difference between the shares’ fair market value and the grant price—is taxed as ordinary income.
When NSO shares are sold, any gain or loss is treated as capital gain or loss. Holding shares for one year or less results in short-term capital gain, taxed at ordinary income rates. Holding for over one year results in long-term capital gain, typically taxed at lower rates. The cost basis for capital gains is the fair market value on the exercise date.
For ISOs, there is no tax event at grant or exercise for regular income tax. However, the bargain element at exercise is an adjustment for the Alternative Minimum Tax (AMT). This means the bargain element is added to income for AMT calculations, which may trigger AMT liability.
To qualify for favorable long-term capital gains treatment on ISOs, shares must be held for at least two years from the grant date and one year from the exercise date. If these conditions are met, the entire gain from the sale is taxed as a long-term capital gain. If not, the disposition is “disqualifying,” and the bargain element at exercise is taxed as ordinary income.
Evaluating Your Decision
Deciding whether to exercise company stock options requires analyzing your personal financial situation. Assess your liquidity to afford the exercise price, especially for a cash exercise. Consider if concentrating wealth in one company’s stock aligns with your overall diversification strategy.
Evaluate the company’s outlook, including its financial health, growth prospects, and industry trends that could impact its stock price. This information helps assess the options’ potential future value.
Your financial goals and the option’s expiration date are also significant. Options have a finite life, so understanding their proximity to expiration can influence your decision. Aligning exercise with long-term objectives, like saving for retirement or a major purchase, provides a strategic perspective.
Understanding the potential tax impact is important. Tax consequences can be complex, especially with ISOs and the Alternative Minimum Tax. Consult a qualified tax advisor to understand specific implications and plan accordingly.