This article was contributed by Wealth Advisor John Zachary.

This article is Part II of a series on stock compensation plans. Part I discussed restricted stock units and can be found here. In addition to these articles, Pathfinder Wealth Consulting will be holding a special webinar on this topic in the coming weeks. For more details on the event, please email [email protected].

Stock options plans, per the name, give you the “option” to purchase shares of company stock at a predetermined price, known as the grant, exercise, or strike price. A company will award an employee a certain number of shares, subject to a vesting schedule. As the vesting schedule is fulfilled, typically over several years, the employee has the right to “exercise” the options, meaning they can purchase the shares at the predetermined price.

If the market price is above the grant price, the shares are considered exercisable and “in the money.”

If the market price is below the grant price, the shares are considered “out of the money” and are effectively worthless until the market price goes above the grant price.

Furthermore, there is an expiration date, which means if your stock options expire before you exercise, or if the market price of the stock never goes above your grant price, your stock options expire worthless.

There are two different types of stock options, which is an important distinction as the tax implications vary greatly between the two types.

Incentive stock options (ISOs) are not taxed when exercised and, when sold, the profit is taxed at capital gains rates, not ordinary income rates (which are typically higher). However, ISOs require a vesting period of at least two years and must be held for more than one year after vesting before they can be sold. ISOs are generally only rewarded to top management and highly valued employees, and therefore those who typically have income to cover their lifestyle and can afford to wait to sell.

Non-qualified stock options (NSOs) on the other hand, are taxed as ordinary income as soon as they are exercised, based on the difference between the market price and the grant price. If the stock is held for at least one year, any capital gains from future sales will be taxed at the long-term capital gains rate. Any capital gains from stock sold prior to the one year holding period will be taxed at ordinary income tax rates (i.e. short-term capital gains rates).

Here’s an example: an employee receives an NSO grant consisting of 1,000 shares of XYZ stock with a grant price of $15 per share. The shares will vest equally over four years, starting on the first anniversary of the grant. One-year from the anniversary of the grant, the employee will have 250 vested stock options. If the stock price is at $10 at that time, the options are “out of the money” since they are below the grant price of $15. However, if the stock price is at $20, then the shares are “in the money” and can be exercised. To exercise the option, the employee purchases 250 shares at the grant price of $15 per share ($3,750) and receives 250 shares worth $5,000 (250 shares at a stock value of $20 per share).

Since this is a non-qualified stock option, at the time of exercise, the employee is taxed on the difference between the market price ($20) and the grant price ($15). Therefore, the employee will pay ordinary income tax on $1,250 ($5,000 - $3,750). Their cost basis for the shares will be $20 per share (or $5,000). Often, folks see the total value of the stock options, not realizing they are only going to benefit from the difference ($1,250 versus $5,000).

If the employee holds the shares and sells all 250 after only 6 months when the stock price has appreciated to $30 per share, the employee will realize a short-term capital gain of $2,500 ($10 per share gain x 250 shares). But if the employee waits and sells all 250 shares 12 months or later from the vest date, when the stock price is at $30 per share, the employee would still have a $2,500 capital gain, but it would be taxed at the lower long-term capital gains rate.

Another option to consider is a “cashless” exercise, in which the employee “borrows” money to buy the shares, immediately selling enough to repay the loan. This is helpful if the employee doesn’t have the cash available to purchase the vested shares.

These are just a few examples of a complicated subject, and unfortunately, the consequence of not understanding the intricacies of these plans may be large tax implications. But that’s where we can help. At Pathfinder, all our wealth advisors have obtained the CERTIFIED FINANCIAL PLANNER TM certification and are specialists in stock compensation plans. We can help you lay out a path for your financial life, including your company stock. Give us a call at 910.793.0616 or register for our upcoming webinar by emailing  [email protected].
 

John Zachary is a Wealth Advisor at Pathfinder Wealth Consulting. Pathfinder specializes in comprehensive financial, estate and tax planning services, investment management, and risk management (insurance) for business owners and successful executives. Advisory services offered through Commonwealth Financial Network®, a Registered Investment Adviser. To learn more about Pathfinder Wealth Consulting, visit www.pwcpath.com. John can be reached at [email protected] or 910-793-0616.