Money Essentials

Types of employee stock options

Can you tell the difference between your employee stock options?


Companies can offer different kinds of plans, depending on what they're trying to get out of the offering.

The various plans offer very different tax advantages and disadvantages, both to the company issuing the options and to the employee receiving them. In general, most options fall into one of two categories: nonqualified options or incentive stock options.

Nonqualified stock options

These are the stock options of choice for broad-based plans. Generally, you owe no tax when these options are granted. Rather, you are required to pay ordinary income tax on the difference, or "spread," between the grant price and the stock's market value when you purchase ("exercise") the shares. Companies get to deduct this spread as a compensation expense.

Choosing the right moment to exercise is not as easy as it looks. For example, let's say you were granted an option to buy 1,000 shares at $5 per share. The stock hits $10 in the public market, at which point you cash in because your grant is about to expire. Your exercise price nets you a gain of $5,000 in this example, which you'd claim on your tax returns as ordinary income.

Now, let's say you think the stock is going to go higher, so you hold onto the shares. Sadly, the market crashes, bringing your shares down to $5, at which point you sell. Here's the bad part: you still owe income tax on that $5,000 profit, even though you never turned it into cash.

From the IRS point of view, that gain was income, which you chose to use to make an "investment" in the stock you kept. If you subsequently sold those shares at $5, you will get a $5,000 capital loss to show for your efforts, which will offset your notional gain somewhat but not entirely.

In a happier example, let's say you hold on, and the stock rises. Any subsequent appreciation in the stock is taxed at capital gains rates when you sell. Keep the stock for more than a year, and you'll have a long-term capital gain, taxed at a top rate of 15%; hold for one year or less, and your gain is short term, taxed at higher, ordinary income tax rates.

Nonqualified options can be granted at a discount to the stock's market value. They also are "transferable" to children and to charities, provided your company permits it.

A safe way to deal with potential uncertainty in share prices is to take out some cash when you exercise, at least enough to cover the tax bill.

An even more conservative way to deal with stock options is to view them exactly the way the IRS does: as income. When you decide to exercise, take 100% of your profits in cash - don't hold onto any shares. Then, manage that money as you see fit.

Incentive stock options

These are also known as "qualified" stock options because they qualify to receive special tax treatment. No income tax is due at grant or exercise. Rather, the tax is deferred until you sell the stock.

At that point, the entire option gain (the initial spread at exercise plus any subsequent appreciation) is taxed at long-term capital gains rates, provided you sell at least two years after the option is granted and at least one year after you exercise.

ISOs give employers no tax advantages and so generally are reserved as perks for the top brass, who tend to benefit more than workers in lower income tax brackets from the capital gains tax treatment of ISOs.

High-paid workers are also more likely than low-paid workers to have cash to buy the shares at exercise and ride out the lengthy holding period between exercise and sale.

If you don't meet the holding-period requirements, the sale is ruled a "disqualifying disposition," and you are taxed as if you had held nonqualified options. The spread at exercise is taxed as ordinary income, and only the subsequent appreciation is taxed as capital gain.

Unlike nonqualified options, ISOs may not be granted at a discount to the stock's market value, and they are not transferable, other than by will.

Two warnings apply here:

1. No more than $100,000 in ISOs can become exercisable in any year.

2. The spread at exercise is considered a preference item for purposes of calculating the dreaded alternative minimum tax (AMT), increasing taxable income for AMT purposes. A disqualifying disposition can help you avoid this tax.

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