By Bill Gallagher, CFP®, MPAS®

With more and more companies offering equity compensation packages to their employees, it is important for those receiving these benefits to understand the features of these different types of compensation. In my previous article we discussed restricted Stock awards (RSA) and restricted stock units (RSU). This article will focus on employee stocks options, which include:

• Non-qualified stock options (NQSO)
• Incentive stock options (ISO)

Before we get into the features of employee stock options, I think it is important to cover some of the terminology associated with this form of equity compensation:

• Grant or award – when you receive the stock option from the company
• Vesting – the time that you have to wait before you can exercise an option
• Vesting period – the time period over which the options become vested, as set out in the option agreement
• Exercise – when you notify the company that you would like exercise your option to purchase stock
• Exercise price or strike price – the price you pay for the underlying shares of stock when you exercise an option. For example, when you have an option to purchase 500 shares at $10 per share, $10 is the exercise price.
• Spread – the difference between the current value of the stock and the strike price

An employee stock option is the right to purchase shares of company stock at a predetermined price. The two types of employee stock options are:

1. Non-qualified stock options (NQSO)
2. Incentive stock options (ISO)

While NQSOs and ISOs share similar mechanical features, they are very different from an income tax perspective. The good news is that the employee does not have to report income upon the grant of options or when the options vest. However, when an employee chooses to Exercise their options, they may have to report the income in the year of exercise. And this is where it gets tricky. In the event an employee exercises a NQSO she will have income to report. However, if she exercised an ISO, she would not have to report the income, but she may have to pay alternative minimum tax (AMT). As you can see there are many moving parts with the income tax associated with employee stock options. So let us now take at the tax characteristics of both NQSOs and ISOs.

As mentioned above, an employee does not have to report income when she grants NQSOs or ISOs. In addition, she will not have to report income as the options vest over time. It is only when she chooses to exercise the options when she will have to report the income. When the options are exercised, she will have to report income equal to the spread. As a reminder, the spread is the difference between the current value of the stock and the exercise price (the amount you pay for the stock). This income is reported as compensation income and is reported on the employee’s W-2. Therefore, the amount is subject to federal, state, Social Security, and Medicare withholding.

• NQSO Example: An employee receives a NQSO grant for 500 shares of company stock with an exercise price of $10 per share. The options are subject to a one-year vesting period. The employee will not have to report compensation income when she receives the grant or when the options vest in one year. Eighteen months later she decides to exercise her options. At that time the current market value of the stock is $25 per share. Given these facts, she will need to report the spread of $7,500 as compensation income in the year of exercise. This amount will be included on her W-2 and will be subject to tax withholding.

Since the $7,500 was included in income, this amount is added to the price she paid to purchase the shares ($5,000) and her basis, for purposes of measuring capital gains tax when she eventually sells the shares, will be $12,500.

• Continuing our example from above, if the shares are sold for $17,500, she will have a capital gain of $5,000 (the difference between the market value at sale and her basis). If she held the shares for more than a 12-month period after the exercise date, then the $5,000 gain will be considered a long-term capital gain, which will be subject to a more favorable tax rate. However, if the shares were held less than a 12-month period after the exercise date, then the $5,000 will be reported as a short-term capital gain and taxed at her marginal tax rate.

When we compare the taxation of NQSOs to ISOs we will see that the rules are more complex. However, with this complexity comes the opportunity for employees to convert some or all of the profit (the spread) into a long-term capital gain, which is subject to a lower tax rate than ordinary income. Unfortunately, the IRS does not allow this tax benefit without a caveat – the alternative minimum tax (AMT). In order to take advantage of converting the spread as a capital gain, the employee must meet both of the following special holding periods:

• The stock must be held for one year after the date of exercise, and
• The stock must be held for more than two years after the option was granted

If the stock is sold before these requirements are met then the transaction will be considered a disqualifying event, in which case the spread is subject to ordinary income.

• ISO Example: On July 1, 2021 an employee receives an ISO grant for 500 shares of company stock with an exercise price of $10 per share. The options are subject to a two-year vesting period. The employee will not have to report compensation income when she receives the grant or when the options vest in two years. On August 1, 2023, after the options have fully vested, she decides to exercise her options. At that time the current market value of the stock is $25 per share. Since these are ISOs, she will not need to report the spread of $7,500 as compensation income in 2023. However, this amount will be added to the AMT calculation for the year, which may result in her paying additional tax in the form of AMT. If she sells her shares after August 1, 2024, then all of her profit (including the amount of the spread) will be taxed as a long-term capital gain.

What happens if the employee sells her shares before the end of the special holding period? In this event, she will disqualify the options from the tax benefits awarded to ISOs and taxed similar to NQSOs.

• Disqualifying Disposition Example: On July 1, 2021 an employee receives an ISO grant for 500 shares of company stock with an exercise price of $10 per share. The options are subject to a two-year vesting period. The employee will not have to report compensation income when she receives the grant or when the options vest in two years. On August 1, 2023, after the options have fully vested, she decides to exercise her options. At the same time, she decides to sell all of the newly acquired shares at the current market value of $25 per share. Since she did not hold the shares for one year after exercise, she will disqualify the shares from the special tax benefit. Therefore, the spread of $7,500 will be included as compensation income for the year and her basis in the shares will equal $12,500 (the amount she paid for the stock and the spread), resulting in a capital gain of $12,500. Since the shares were held less than one year the gain will be considered a short-term capital gain.

Now that we understand the mechanics of employee stock options and how they are taxed I would like to briefly cover a few different options an employee has in order to purchase the shares.

• Cash exercise: with a cash exercise the employee pays for the shares out-of-pocket. For example, an employee has an option to purchase 100 shares of company stock at $10 per share. When she exercises these options, she will need to write a check to her company in the amount of $1,000.
• Cashless exercise (or sell-to-cover): when an employee chooses a cashless exercise, she will instruct her company to liquidate enough of the shares to cover the purchase amount. The net shares will then be delivered to the employee.
• Stock Swap: if the employee already owns shares of company stock, she may be able to use those shares to cover the purchase amount. The employee would swap the shares she owns with her company for the newly issued option shares.

With equity compensation becoming more popular, it is important for employees to not only understand the form of equity they receive but to also understand the tax consequences. In addition, it is important to incorporate the stock options you receive in your overall financial plan. How do stock options impact your long-term goals and objectives? How does the equity fit into your risk tolerance and other investments? What is my tax situation? Should I exercise and hold the shares? Or should I consider a cashless transaction? If you find yourself in the fortunate position where your company is providing you with equity compensation, then I would strongly recommend you reach out to your financial planner so that you can get a comprehensive look at how the equity compensation impacts your financial situation.

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