Understanding Stock Options

How Do Options Work?

Stock options, once vested, give you the right to purchase shares of your company’s stock at a specified price, usually called the strike or exercise price. Each option allows you to purchase one share of stock. The value of a stock option depends on the price of the company’s shares, which fluctuates over time.

A stock option is said to be “vested” when the holder has the right to purchase the shares at the predetermined price. Stock options may vest over a set schedule.

As an example, consider if you were given a grant of 100 stock options with an exercise price of $10 each. The options are fully vested after three years, and the company’s share price has risen to $25. You are now entitled to buy the shares for $10, a full $15 below the current stock price. This process of purchasing the shares underlying the option is known as “exercising” the option.

Know The Types Of Stock Options

Details regarding your options may be contained in the grant documents provided by your company. Before taking action on your stock options, review the company’s plan.

Incentive Stock Options (ISOs)

ISOs are eligible for preferential tax treatment upon meeting holding requirements and other requirements under the tax code. Federal income taxes are generally not due at exercise. Rather, income taxes due are generally deferred until the holder sells the stock received as a result of exercise.

Non-Qualified Stock Options (NQSOs)

In contrast to ISOs, NQSOs are not eligible for preferential federal tax treatment when exercised. NQSOs result in taxable ordinary income to the recipient at the time that they are exercised.

Understanding Exercise Types

The exercise types shown here may, or may not, be available to you. Refer to the grant documents provided by your company to understand what exercise types are available to you.

Same-Day Sale (Cashless Exercise)

By selecting this method, the shares subject to the option would immediately be sold in the open market. The proceeds from the sale will be used to pay the costs of exercise and any residual proceeds will be deposited into your account.

Cash Exercise (Exercise and Hold)

By selecting this method, you would need to deposit funds into your account to cover the costs of exercise. The resulting shares will be deposited into your account.

Sell-To-Cover

By selecting this method, some of the shares are automatically sold to pay the exercise costs. The remaining shares (if any) are deposited into your account.

U.S. Tax Considerations

The following tax sections relate to U.S. taxpayers and provide general information on federal tax treatment. State and local taxes may vary. For those who are non-U.S. tax payers, please refer to your local tax authority for information.

Before you take action on your shares, you’ll want to carefully consider the tax consequences. The information contained in this document is for informational purposes only. Tax treatment depends on a number of factors including, but not limited to, the type of award. For advice on your personal financial situation, please consult a tax advisor.

Potential Taxes on Exercise

ISOs: In most cases, no taxes are due at exercise. Exercise may be subject to tax under the alternative minimum tax rules.

NQSOs: Taxes at exercise are based on the difference between the stock price on the date of the exercise and the option exercise price. This amount is typically taxable in the year of exercise at ordinary income rates.

Potential Taxes at Sale

ISOs

Ordinary Income: The amount of ordinary income recognized when you sell your shares from an ISO exercise depends on whether you make a qualifying or disqualifying disposition. A sale of shares from an ISO exercise can be considered a qualifying disposition and generally will avoid ordinary income tax upon exercise if, among other requirements, the following conditions are met:

1.     You hold the shares for more than one year after the date of purchase (the exercise date), and

2.     You hold the shares for more than two years after the option grant date.

Capital Gain or Loss: In general, selling shares from an ISO exercise in a qualifying disposition will not trigger ordinary income and the entire gain or loss (sales price minus cost of the shares) will be considered a long-term capital gain or loss.

If you fail to satisfy the requirements described above, your sale of shares from an ISO exercise will be considered a disqualifying disposition. In general, selling stock in a disqualifying disposition will trigger ordinary income. The amount of ordinary income is generally the difference between the stock price on the date of the exercise and the option exercise price. Your employer should report the ordinary income from the disqualifying disposition on your Form W-2 or other applicable tax documents. Any remaining gain or loss will be considered short- or long-term capital gain or loss, depending on how long you held the shares after exercise. If you held the shares one year or less, the gain or loss would be short-term. If you held the shares more than a year, the gain or loss would be long-term.

NQSOs

Ordinary Income: Upon exercise of NQs, the difference between the stock price and the exercise price is taxable as ordinary income. No additional ordinary income is recognized upon the sale of shares from a NQSO exercise.

Capital Gain or Loss: Any difference between the stock price on the exercise date and the stock price at sale will be treated as a capital gain or capital loss. If shares are held for more than one year after exercise, any resulting gain is typically treated as a long-term capital gain.

Potential Taxes on Dividends

If you exercise your options and hold the shares, any dividends received on your shares are considered dividend income and are taxed as such in the year they are received.

Exercising Your Options

If you choose to exercise your vested options, you can then sell the shares (subject to any company-imposed trading restrictions or blackout periods) or hold them until you choose to sell or otherwise dispose of them.

Deciding what to do with your stock options can be a big financial decision. If you have questions, you may wish to speak with a professional, like a Financial Advisor, who can help you determine what might be a good fit for your financial situation and goals.