What Happens to Stock Options When You Are Laid Off?

Stock options are a valuable part of an employee’s compensation, offering a share in a company’s future success. Their treatment upon employment termination, such as a layoff, introduces complexity. Understanding the specific provisions of one’s stock option plan is important in such situations. Employees should review the details governing these benefits to make informed decisions.

Key Terms and Option Types

A stock option provides an employee with the right, but not the obligation, to purchase a specific number of company shares at a predetermined price, known as the “exercise price” or “strike price.” The “grant date” is when the company issues these options to the employee, and it sets the exercise price.

Options become available for purchase according to a “vesting schedule,” a timeline over which an employee gains ownership rights. For example, a four-year vesting schedule allows a portion of options to become exercisable each year, requiring continued employment. The “expiration date” is the final day an employee must exercise their options.

Stock options fall into two categories: Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). NSOs are a common form of equity compensation for employees. They offer flexibility but do not receive special tax treatment at exercise under federal tax law.

ISOs are a type of option reserved for employees. ISOs offer preferential tax treatment compared to NSOs, provided certain holding period requirements are met. This difference impacts how and when gains from these options are recognized for tax purposes upon exercise and sale.

Impact of Layoff on Vested and Unvested Options

A layoff impacts an employee’s stock options, distinguishing between vested and unvested options. Unvested options are forfeited when employment terminates, including due to a layoff. This occurs because the conditions for vesting, which involve continued employment, are no longer met.

Vested options are not forfeited upon layoff. Instead, they become subject to a limited post-termination exercise window. This window is shorter than the original expiration date, often 30 to 90 days following the last day of employment. Failing to exercise vested options within this timeframe will result in their forfeiture.

The terms governing this post-termination exercise window vary by company. Employees must review the stock option plan document provided by their employer. This document outlines the exercise window and any other conditions that apply after a layoff.

Exercising Vested Options After Layoff

Exercising vested stock options after a layoff requires understanding the company’s procedures. The first step is to review the company’s stock option plan document. This document contains information like the post-termination exercise window and the designated contact.

The plan details the process for initiating an exercise. Common methods include a “cashless exercise,” a “cash exercise,” and a “sell-to-cover” exercise. A cash exercise requires the employee to use their own funds to purchase shares at the exercise price. A cashless exercise involves a brokerage firm providing a loan to facilitate the purchase, with shares sold immediately to cover the cost. A sell-to-cover exercise sells a portion of the newly exercised shares to cover the exercise price and taxes, with remaining shares delivered to the employee.

Contact the designated plan administrator or broker to begin. This initiates the process of requesting forms or accessing an online portal. Submit the exercise order by filling out forms or navigating the online portal. After submission, shares are deposited into a brokerage account, funds are transferred, and a confirmation is provided.

Tax Treatment of Exercised Options

The tax implications of exercising stock options, particularly after a layoff, are complex and depend on the option type. For Non-Qualified Stock Options (NSOs), the difference between the fair market value (FMV) of the stock on the exercise date and the exercise price is taxed as ordinary income at exercise. This income is subject to federal income tax, Social Security, and Medicare taxes. Upon the subsequent sale of shares, any gain or loss from the FMV at exercise is treated as a capital gain or loss.

Incentive Stock Options (ISOs) do not incur ordinary income tax at exercise. However, the spread between the exercise price and the fair market value at exercise for ISOs can be subject to the Alternative Minimum Tax (AMT). The AMT is a separate tax calculation designed to ensure that taxpayers with significant deductions or preferential income pay a minimum amount of tax, and the “bargain element” of ISOs at exercise is an adjustment for AMT purposes.

The tax treatment upon the sale of ISO shares depends on whether it is a “qualified disposition” or a “disqualified disposition.” A qualified disposition occurs when shares are held for at least two years from the grant date and at least one year from the exercise date. In this case, the entire gain is taxed as a long-term capital gain, which has lower tax rates than ordinary income. A “disqualified disposition” occurs if shares are sold before meeting both holding period requirements. In a disqualified disposition, the gain equal to the spread at exercise (or the FMV at sale if lower) is taxed as ordinary income, while any additional gain is treated as a capital gain.

Tax withholding requirements for NSOs mean employers withhold income and payroll taxes on the ordinary income recognized at exercise. Employees receive tax forms related to stock option activity, such as Form W-2 for NSO income and Form 3921 for ISO exercises. Consulting with a qualified tax professional is recommended for personalized advice.