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How Employee Stock Options Work


A corporation has three main ways to pay its employees. The primary type of compensation, of course, is cash, which comes in the form of hourly wages, contract income, salaries, bonuses, matching retirement plan contributions, and lifetime payouts from defined benefit plans.

The second method of compensation comes in the form of benefits, such as insurance (life, health, dental, and disability), paid vacations and sick days, tuition and child care assistance, and other miscellaneous perks, such as company cars and expense accounts.

But many employers also reward their workforce by allowing them to purchase shares of stock in the company at a discount. Stock compensation comes in many forms, and is popular with both employers and employees for many reasons. However, it does pose some potential drawbacks.

How Employee Stock Options Work

Although the particulars vary from one form of stock compensation to another, the basic idea behind most forms is to provide workers with the means to buy company stock which they can then sell.

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Stock options have three important dates:

1. The Company Grants the Stock Options

The process of providing stock compensation usually begins by granting employees the right to purchase shares of the company’s stock. The employer issues an agreement giving employees the option to purchase a set number of shares at a predetermined price, also known as the grant price or the strike price. The option to buy the stock becomes active on a specific date known as the grant date.

2. The Employee Exercises the Stock Options

Once the company grants an option to buy stock, the employee can purchase the stock according to the plan rules.

Companies rarely allow an employee to purchase all of the stock right away. Instead, the agreement includes a vesting schedule.

For example, say you start a new job and your employer gives you stock options for 12,000 shares of the company’s stock, but the agreement calls for a four-year vesting period and a one-year cliff.

The one-year cliff means you have to stay at the company for at least one year before you can exercise stock options. The four-year vesting period means you can purchase one-quarter of your options each year over a four-year period. So on your first anniversary you can buy 3,000 shares, another 3,000 shares on your second anniversary, and so on.

The agreement usually has an expiration date. If you don’t exercise your options before the expiration date, you lose your right to purchase the stock at that price.

Most option agreements allow the employee to buy the stock either at a specific predetermined price, or at the price it was trading at on the grant date. This means the employee can buy the stock at a discount if it has risen in price by the time they exercise the option.

3. The Employee Sells Their Shares of Company Stock

This is when employees liquidate shares of stock they purchased. Employees can hold stock as long as they want or sell it right away. 

For example, say you exercise an option to purchase your employer’s stock at $45 a share. On the day you exercise that option, the stock is worth $90 per share. In that case, you realize an instant $45 per share gain simply by exercising the option to buy at $45 and then selling the stock in the open market.

Taxation of Company Stock Compensation

The income tax rules for stock options vary with each type of plan.

Incentive Stock Options

Incentive stock options (ISOs) give employees the opportunity to buy shares of the company’s stock — usually at a set price lower than its fair market value.

You generally don’t have to pay income tax when you exercise an ISO. If you hold the stock at least one year after exercise and two years after the grant date, the IRS taxes your gain as a long-term capital gain, and it qualifies for special tax treatment.

The catch is that you may have to pay the alternative minimum tax (AMT) on the difference between the price you paid for the shares and their fair market value. You’ll need to file Form 6251 with your tax return in the year of exercise to determine whether you owe the AMT.

Nonqualified Stock Options

The tax treatment of nonqualified stock options, also known as nonstatutory stock options (NSOs), depends on whether the value of the stock is readily ascertainable.

For example, say you work for Apple and receive stock options. Apple stock is actively traded on an established securities market, so it’s easy to find out what it’s worth on the day your employer grants the options.

If the value is readily ascertainable, then the NSOs are taxable at the time of the option grant. You owe ordinary income tax on the difference between the strike price and its value on the grant date. This income will be included on your Form W-2 at year end.

On the other hand, say you work for a startup whose stock isn’t traded on an established securities market. In that case, your options are taxable when you exercise your options. You owe federal income tax at your ordinary income tax rate on the difference between what you paid for the stock and its value on the exercise date.

In both cases, you may owe tax again when you turn around and sell the shares. If you hold on to the shares for one year after exercising the option or two years from the grant date, any gain will be taxable as a long-term capital gain. If you don’t meet that holding period requirement, your gain is short-term and taxed at ordinary income tax rates.

Advantages of Employee Stock Options

For employees, stock options mean additional compensation in the form of discounted stock purchases. In many cases, the options themselves come to have tangible value, particularly if the employee is able to exercise the option at a price far below where it is currently trading. Workers can also benefit from knowing that their efforts are at least indirectly contributing to the rise in the value of their investment.

For employers, the benefit of stock options is that it’s cheaper and easier for the company to simply issue shares of stock than pay cash to employees. 

Stock options can also increase employee motivation because workers who own a piece of their employer get to share directly in the profits of the company in addition to receiving their weekly paychecks. This can improve employee morale and loyalty, reduce employee turnover, and create another group of investors buying company shares.

Disadvantages of Employee Stock Options

If the value of the company’s stock declines, then so does the value of the employee’s options or shares. Employees with substantial amounts of stock or options can see their net worths decline sharply in a very short period.

Also, immediately selling a large number of shares purchased with stock options will lead to substantial short-term capital gains tax, which can drastically increase the employee’s tax bill for that year. 

When company stock loses value, it can leave employees feeling discouraged and lead to reduced productivity and morale. Depending on the reason for the stock value’s decline, the lack of employee motivation could drag the company, and thereby its stock, down even further.

Other Types of Stock Compensation

Besides ISOs and NSOs, there are a few other types of stock options you might encounter.

Restricted Stock and Restricted Stock Units (RSUs)

Many corporate executives and insiders who are awarded company stock are only allowed to sell the stock under certain conditions, such as requiring the executive to wait for a certain period of time before selling. These restrictions are designed to comply with regulations aimed at curbing insider trading. This is known as restricted stock. 

Restricted stock units (RSUs), on the other hand, are a device to grant shares of stock or their cash value at a future date according to a vesting schedule without conveying actual shares or cash until the vesting requirement is satisfied.

Employee Stock Purchase Plans (ESPPs)

This is perhaps the simplest type of employee stock purchase program. ESPPs are funded via payroll deduction on an after-tax basis. The employer diverts a portion of the employee’s compensation into an ESPP account that accumulates money from the time of offer or enrollment until the purchase date. 

Most ESPP plans allow employees to purchase their company stock at up to a 15% discount from the current market price. These plans can be qualified, which allows for long-term capital gains treatment under certain conditions, or nonqualified depending on plan type and how long the stock is held before it is sold.

Employee Stock Ownership Plans (ESOPs)

An ESOP is a type of qualified plan that is funded entirely with company stock. ESOPs are often used by closely held businesses as a way to provide a liquid market for the company stock on a tax-advantaged basis; owners can place their shares of the company inside the plan and then sell these shares back to the company at retirement. 

These are perhaps the best plans available from a tax perspective because income from the sale of stock is never recognized until it is distributed at retirement, just as with any other type of qualified plan.

Employer Stock Offered Inside a 401k

This form of retirement plan funding came under close scrutiny by regulators after the Enron and Worldcom meltdown in 2002. 

According to the Financial Industry Regulatory Authority (FINRA), nearly 60% of Enron employees had their 401(k) assets invested in the company’s stock when it lost nearly all of its value in 2001.

Although many employers still dole out company shares to employees in their retirement plans, employees need to ensure that they are adequately diversified in their retirement portfolios according to their risk tolerances and investment objectives.

Phantom Stock and Stock Appreciation Rights (SARs)

Phantom stock is named as such because there may be no real shares of stock issued or transferred. This type of stock is typically geared to benefit executives and key employees, who may be required to meet certain requirements in order to be eligible for the plan. 

The “stock” is often paid to an employee in the form of so-called performance units that represent shares of the actual stock. Employees receive many of the financial benefits of stock ownership without actually owning the stock. 

Stock appreciation rights (SARs) usually pay employees the value of the growth in the company stock over a predetermined period of time. This payment may be in cash, or it can be done with actual shares in some cases.

Final Word

Stock compensation is one of the most versatile forms of payment available for both employers and employees. However, one of the challenges that many workers face is knowing how their company’s stock can or should fit into their own financial plans. Although company stock can often provide substantial gains over time, it can also create taxable events, in some cases even when no cash is realized.

To learn how your stock compensation program works, including how and when you’ll be taxed on gains, consult your HR department or financial advisor.

Janet Berry-Johnson is a Certified Public Accountant. Before leaving the accounting world to focus on freelance writing, she specialized in income tax consulting and compliance for individuals and small businesses. She lives in Omaha, Nebraska with her husband and son and their rescue dog, Dexter.