There are many reasons why a company would offer stock options in its benefits packages. Many small and mid-sized companies do so because they can’t afford to pay their employees as much as some other companies can but their company is growing and they can offer the employees a piece of the success. Others do so in order to incentivize the employees because when the company does well, they do well.
How stock options work
Stock options have a limited time frame in which employees can purchase stock at a discounted price, which may be called the grant price, strike price, or exercise price. This pre-set price is only good until the deadline, and many stock option contracts include a clause that the option closes if the person leaves the company before the deadline. The options may also have a start date, a period of time in which the employee must remain employed before receiving the right to exercise his or her option. This is similar to 401k vesting periods. A vesting schedule might restrict the number of stock options that can be exercised to spread them out over a number of years of employment.
Stock options can also be extended to employees, contractors, consultants, and investors. Stock options granted to employees as incentive stock options (ISO) are statutory stock options. Those plans offered to consultants and others are non-statutory stock options (NSO). ISO and NSO are treated very differently for tax purposes.
Taxation on ISO and NSO plans
The taxation of stock options can be very complicated, and a good tax accountant will study in depth in order to advise his or her clients about whether an ISO or NSO would be better and how long to hold the stock in order to receive the maximum financial benefit with minimum tax effect.
As a general rule, there is no tax effect when a person exercises a stock option by purchasing stock. Profit is taxed at the time of sale; the spread between the strike price and selling price for an ISO is taxed at the capital gains tax rate, while the spread of an NSO is taxed at the owner’s regular tax rate and is subject to all withholdings.
Since the capital gains rate is below most personal tax levels, the ISO is usually preferred. However, if the person is in a very low tax bracket, or if the person is planning on selling within the year, NSO may prove a better option.
Alternative Minimum Tax (AMT) may also impact the decision to exercise ISO or NSO and when to sell. Looking closely at your client’s financial position will help you provide accurate guidance.
There are also a variety of stipulations and exceptions. For instance, in the case of an ISO, stock must be held for at least one year AND it must be at least two years since the option was granted in order to receive the preferred long-term capital gains rate. Otherwise, it will be taxed as an NSO – the spread is treated as ordinary income.
Stock options and employers
If you have an employer who is considering offering stock options, you will have to discuss many factors. A few include:
- The specifics of the stock option contract: who it will be offered to, the vesting period, closing date, strike price, number of options permitted to be exercised, stipulations on options when an employee leaves, is fired, or dies, how employees will pay for the purchases, and other details
- The total number or percentage of shares to be issued under the plan, usually between 5 and 20% of stock total to prevent dilution of stock
- Who will administer the plan and provide financial reporting
- Approval of the plan by other shareholders and the board, if there is one
- Right of first refusal, which will give the employer the opportunity to limit the number of shareholders
- Compliance with securities laws
- Valuation of the stock – this is important for non-trading stocks since trading stocks have a valuation on the market already
Whether your clients are employers or employees, by studying the details of the tax code regarding stock options, you can be their valued financial advisor who helps them choose the best options to grow their financial position.