What Is a Share Option and How Do They Work?
Demystify employee share options. Grasp their core function, how they operate, and their financial and tax considerations.
Share options are a common form of employee compensation, allowing companies to attract, motivate, and retain talent. They offer employees a chance to share in the company’s growth by providing the right to purchase company stock at a predetermined price. This aligns employee interests with the company’s success, as the value of their options is tied to stock performance.
Understanding Share Options
A share option grants an employee the contractual right, but not the obligation, to buy a specified number of company shares at a fixed price. This fixed price is known as the grant price. The grant date is the specific day the company awards these options to the employee.
Options typically come with a vesting schedule, a timeline dictating when the employee can exercise their options. This schedule often requires continued employment over a period, such as becoming fully vested in portions annually over several years. Once options vest, an exercise period begins, defining the timeframe during which the employee can purchase the shares. If options are not exercised within this period, the opportunity to purchase shares at the predetermined price is lost.
How Share Options Work
The process begins with granting, where the company formally offers options to an employee, specifying the number of options and the exercise price. Options are not actual shares; they are a right to buy shares in the future.
After granting, a vesting schedule dictates when the employee can exercise their options over time. Once options vest, the employee can exercise them by purchasing shares at the preset grant price. This converts the option into actual stock ownership.
After exercising, the employee owns the shares and can decide to hold or sell them. If the market value of the shares exceeds the exercise price, the employee can realize a profit from the difference.
Types of Share Options
Share options primarily fall into two categories: Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). ISOs can only be granted to common-law employees of the company. They must be granted with an exercise price at or above the fair market value of the company’s stock on the grant date. There are also limitations on the value of ISOs that can become exercisable in any given calendar year, with any excess often treated as NSOs.
Non-qualified Stock Options, in contrast, do not need to meet the strict Internal Revenue Code requirements that apply to ISOs. This greater flexibility means NSOs can be granted to a broader range of individuals, including employees, consultants, advisors, and board members. Unlike ISOs, there is no limit on the value of NSOs that can be granted in a year.
Taxation of Share Options
The tax treatment of share options varies significantly based on whether they are Non-qualified Stock Options (NSOs) or Incentive Stock Options (ISOs).
Taxation of Non-qualified Stock Options (NSOs)
NSOs are not taxed at the grant date or during the vesting period. The primary taxable event occurs when the employee exercises the options. At this point, the difference between the fair market value (FMV) of the stock on the exercise date and the exercise price is considered taxable ordinary income. This amount is included in the employee’s wages and is subject to federal income, Social Security, and Medicare taxes.
When shares acquired through NSOs are subsequently sold, any additional gain or loss is treated as a capital gain or loss. If held for one year or less after exercise, profit is a short-term capital gain taxed at ordinary income rates. If held for more than one year, profit is a long-term capital gain taxed at lower preferential rates.
Taxation of Incentive Stock Options (ISOs)
ISOs offer potentially more favorable tax treatment. There is no regular income tax due at grant or exercise. However, the “bargain element” (the difference between the FMV at exercise and the exercise price) is an adjustment for Alternative Minimum Tax (AMT) purposes. This can trigger an AMT liability, especially for high-income earners, even if no shares are sold.
For the most favorable tax treatment (a “qualified disposition”), ISO shares must meet two holding period requirements before sale. 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 (difference between sale price and exercise price) is taxed at long-term capital gains rates.
If holding period requirements are not met, it results in a “disqualifying disposition,” and tax treatment becomes less favorable. In this scenario, the difference between the exercise price and the FMV on the exercise date is taxed as ordinary income. Any additional gain beyond the FMV at exercise is taxed as a capital gain (short-term or long-term, depending on the holding period after exercise).