Employee stock options can be a valuable part of a compensation package. They can also be misunderstood. Here is a quick guide to walk through some of the common questions that we get from clients and prospective clients regarding employee stock options, as well as some additional items to consider.
There is the possibility you found this blog by searching “employee stock options,” but you may not have options at all (more on that later). There is also a reasonable chance that you do, in fact, have employee stock options available to you (hence why you conducted the Google search in the first place). So, let’s define employee stock options.
TYPES OF EMPLOYEE STOCK OPTIONS
Investopedia defines employee stock options as “a type of equity compensation granted by companies to their employees and executives.” They are considered derivatives because the value of a stock option is derived from the price of the underlying stock. If you own a stock option you do not own the actual stock itself. Rather, you have the right to buy the stock at a predetermined price (the strike price). If the price of the actual stock is greater than the strike price, the option is considered “in the money”. Of course, you’d rather have an option that is in the money than out of the money; an out-of-the-money option is worthless! There are two main types of employee stock options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs, or sometimes you’ll see NQSOs). They are treated differently than standardized options contracts that trade on an exchange. Standardized options contracts are similar in that they may give someone the right to buy (or sell) a stock at the strike price, but anyone can own them (you don’t have to be an employee of the company). Investors can buy or sell standardized options contracts to hedge risk, generate income, or use them speculatively.
ISOs and NSOs are similar in that they give the employee the right to buy the stock at the strike price. They are also both subject to a vesting schedule. Once options vest, the employee can exercise the option. For example, let’s say an employee is awarded 1,000 options (either ISOs or NSOs) that vest over a four-year period. Assuming that they are still with the company and have met the criteria outlined in the stock award’s plan document, the employee vests 25% after one year passes. They are then able to exercise 250 options (i.e. they buy the stock at the strike price). If the strike price of the stock is $50, the employee can purchase 250 shares for $12,500. This could be a good deal if the market price of the stock is $100/share! However, the option doesn’t have value when the market price of the stock is $25, for example (why would you want to buy a stock for $50 when it is worth $25?).
Before diving into the rest of this blog, I want to remind you that, although taxation is discussed at a high level, I am not a legal tax advisor! Taxes, especially around the various forms of equity compensation, get complicated. That is why there are good tax advisors and CPAs out there! Please remember that this blog is NOT exhaustive and that it makes sense to work with a financial planner alongside your tax advisor/accountant. Let’s continue.
TAXATION OF EMPLOYEE STOCK OPTIONS
The big difference between ISOs and NSOs is taxation. Generally, ISOs are more favorable from a tax perspective. ISOs may not be taxable when exercised, whereas the difference between the fair market value and exercise price of an NSOs will be subject to ordinary income tax. Note that exercising your ISOs may trigger the Alternative Minimum Tax (AMT). The AMT is essentially a tax code that runs parallel to the federal income tax code. The purpose of the AMT is to ensure that taxpayers with the tools and resources to greatly reduce their tax bill through deductions etc. still have to pay a minimum tax. Most U.S. taxpayers are not subject to the AMT. Your tax preparer will compare your tax liability that is shown on your “normal” tax return (IRS Form 1040) to the tax liability calculated from the AMT, and the taxpayer will have to pay the higher amount.
Without going too far down the AMT rabbit hole, let’s get back to ISO and NSO taxation. There is also a difference in how ISOs and NSOs are treated when the underlying stock is sold. ISOs may provide the opportunity to have a larger share of the gain subject to capital gains tax, compared to NSOs. In the case of the ISO, the difference between the sale price and the exercise price could be subject to capital gains rates. Compare that to the NSO, where the difference between the sale price and the fair market value price on the exercise date could be subject to capital gains rates (all else equal, a smaller portion than the ISO). Why is this important? In most cases, the long-term capital gains rates are lower than the ordinary income tax bracket. For example, someone in the 37% ordinary income tax bracket would be in the 20% long-term capital gains tax bracket (well, it could be 23.8%: 20% capital gains tax + 3.8% net investment income tax). I don’t know about you, but I’d rather have most of my gain generated from my ISOs be taxed at 20% (or 23.8%) rather than 37%! It is also worth noting that depending on the state that you live in, there may be a capital gains tax at the state level in addition to federal taxes. To qualify for the more favorable long-term capital gains rate upon disposing of stock obtained from exercising an ISO, one must hold the stock over one year from the exercise date and over two years from the stock option grant date.
PRIVATE COMPANY VS. PUBLICLY TRADED
How does this change if a company is privately held, compared to a publicly-traded company? In the case of a publicly-traded company, the market value of the stock is pretty easy to determine. Not necessarily the case for a private company. Here in Madison, Wisconsin, there are a lot of people that work for Exact Sciences (publicly traded: EXAS) as well as Epic Systems (private). Both companies have robust equity compensation plans. It is quite easy to find the price of EXAS stock, just ask Siri (she’ll tell you!). On the other hand, try asking Siri to provide you with the price of a share of Epic Systems. Spoiler alert: I tried this, and she will politely respond, “I don’t see the stock ‘Epic Systems’”. Ultimately, Epic obtains an annual assessment of the price of a share of their stock that is approved by the Board of Directors. Disposing of the shares will also be treated differently between a public and private company. If you obtain stock from an employee stock option or another form of equity compensation (assuming fully vested and no remaining restrictions), you can probably sell the stock to any buyer on the open market. With private companies, disposing of the stock typically means that you sell the vested shares back to the company. The stock plan document will describe the logistics of how the transaction occurs. If you sell the stock back to the company, the transaction is subject to capital gains. Taxation of Restricted Stock or a stock option of a private company is typically treated the same as it would a publicly-traded company; however, as always, this is a topic that should be run by your tax advisor.
OTHER FORMS OF EQUITY COMPENSATION
You might be wondering, what about my RSUs, ESPP, SARs, or other flavors of equity compensation that I have through my employer? A trend that we see within the world of equity compensation is an uptick in Restricted Stock Unit (RSU) awards. An RSU isn’t a direct share of the underlying stock. Rather, the delivery of shares of stock occurs after the RSUs vest. An RSU is granted to an employee and is usually subject to a three or four-year vesting schedule. Taxation occurs, at ordinary income rates, when the RSUs vest and the stock is delivered. Once you own the vested stock, taxation is treated just like any other stock: It depends on 1) the holding period (if it is greater than one year or not) and 2) if the stock is sold at a gain or loss. Employee stock options still exist, of course, but RSUs have become more popular since they usually have some value – unless the company stock goes to $0. In the case of ISOs and NSOs, if the options are out of the money, there is no value (technically there might be some “time value,” which is the concept that an option has more value the further away it is from its expiration date). I’ll leave it to Bill Gates to describe it in a way that I couldn’t do better myself:
“When you win [with options], you win the lottery. And when you don’t win, you still want it. The fact is that the variation in the value of an option is just too great. I can imagine an employee going home at night and considering two wildly different possibilities with his compensation program. Either he can buy six summer homes or no summer homes. Either he can send his kids to college 50 times, or no times. The variation is huge; much greater than most employees have an appetite for. And so as soon as they saw that options could go both ways, we proposed an economic equivalent. So what we do now is give shares, not options.”
I’ve had many conversations with people and they find themselves using the terms “Restricted Stock” and RSUs synonymously. Restricted Stock (RS) is different from an RSU! Restricted stock is company stock that is granted to you but you have voting rights and the right to dividends during the vesting period. That is not the case with RSUs. From a taxation perspective, the big difference between RS and RSUs is that the RS has the option to make an 83(b) election. If an employee has RS, the 83(b) election allows the employee to be taxed on the grant date, instead of the default of being taxed at vesting. The 83(b) election might make sense when the employee strongly believes that the price of the stock will increase over time. The thought process is that they would rather get taxed on the grant date when the value of the stock is, say $1000, opposed to when the stock vests when its value is $2000, for example. An 83(b) election is risky. There is a chance that one makes the 83(b) election and is taxed on an amount that is higher than the value when the stock vests or is sold at a later date. In that case, the employee overpaid taxes, and cannot get refunded for the overpayment. Therefore, if the employee thinks that the stock price might go down, they might not want to utilize the 83(b) election. Ultimately they should engage with their tax advisor to take into consideration all other tax-related factors in their decision.
Employee Stock Purchase Plans (ESPP) are also quite common. These plans allow employees to purchase company stock with funds deducted directly from their paycheck, usually at a discount (up to 15%). In the case of an ESPP that has a 15% discount, if the fair market value of the stock is $100 (as defined by the plan document), the employee has the opportunity to buy the stock at $85. Taxation upon sale of stock acquired from an ESPP can be a combination of ordinary compensation income and capital gains. The amount of time that you hold the stock from the offering period (when money is deducted from your paycheck) and the purchase period (when the actual stock is purchased) will determine the type and extent of taxation. ESPP taxation is similar to the tax treatment of ISOs, from the perspective of a qualified disposition (generally favorable tax treatment) vs. a disqualifying disposition (generally not as favorable).
Stock Appreciation Rights (SARs) are another form of equity compensation. We still see SARs, but in our experience much less than RSUs or traditional employee stock options (ISOs & NSOs). With SARs, an employee can profit when the stock appreciates, just like the name implies. Depending on how the plan is set up, the employee can be paid in cash or company stock (taxed as ordinary income upon exercise, regardless if you receive cash or stock). Note that the SAR must be exercised! The payout doesn’t occur automatically when the price of the underlying stock appreciates. Similar to employee stock options like ISOs and NSOs, SARs may have no value, in the case where the stock never appreciates after the SARs were granted. The “gain” (fair market price of the stock minus exercise price) is taxed as ordinary income upon exercise.
As you can see, a taxable event may occur at different stages of the game, depending on what type of equity compensation we are talking about. Many wonder, will I have to pay taxes out-of-pocket? In most cases, you will be able to withhold an amount to account for the tax due from a taxable event. Depending on the type of plan you have, there could be multiple options when it comes to withholding. This is another area where a good review of the plan document will tell you your options.
In some cases where the employee receives cash (e.g. exercise of a SAR where they get their payout in cash instead of shares of stock), the company may simply withhold taxes in the form of cash, similar to withholding from your paycheck. They will withhold for federal & state income tax, Social Security, and Medicare. In a case where the employee is receiving stock (e.g. RSU vests, shares of company stock are delivered to the employee’s brokerage account), the company may withhold the appropriate amount in the form of shares. In that case, the employee receives an amount of shares net of withholding (I’ve also seen it described as “surrendering” shares). By withholding shares, it allows the employee to avoid paying the withholding with cash. Note that just because taxes are withheld doesn’t mean that a taxpayer won’t have to pay anything out of pocket! In other words, there are cases where the tax withheld was too little, and the taxpayer still owes a portion of their tax liability by the time they file their taxes.
Investing comes with risk, although not all risks are equal. Obvious statement ahead, but people participating in the many types of employee stock plans mentioned above want the price of their company stock to go up! However, we know that stocks don’t increase exponentially (or linearly, for that matter) into perpetuity. They can be volatile and in some cases can lose significant value. As discussed earlier, in the case of employee stock options like ISOs and NSOs, forms of equity compensation can lose all of their value. Think back to the Bill Gates quote above. All in all, equity compensation plans can provide a unique opportunity for you to save, invest, and grow your net worth. It doesn’t always work out exactly as planned, but if managed appropriately, equity compensation plans can provide an excellent supplement to help you meet your financial goals in a tax-advantaged way.