For top-level employees and executives, employee stock options are often a major part of their compensation. Qualified stock options are awarded under a special set of Internal Revenue Service rues that make profits eligible for treatment as capital gains income. Non-qualified options don’t come with tax breaks, but have more flexibility when it comes to exercising them and taking profits.
All employee stock options function much like call options traded in securities markets. The holder of the option contract has the right, but is not obligated, to purchase shares of the company’s stock at a predetermined strike price. The option is good until its expiration date, although most companies impose a waiting period before the option can be exercised. Profits from non-qualified stock options are considered ordinary income because the option holder doesn’t actually own the stock. Qualified stock option earnings may be treated as capital gains, however, even those that accrue from increases in the stock price between the time the option is issued and when it is exercised.
Qualified Option Rules
In order for an employee to be eligible to receive qualified stock options, he must be employed by the company (or a subsidiary). The strike price of the option has to be equal to or higher than the stock’s market price at the time the option is awarded. To meet the requirements for capital gains tax rates, the employee must wait at least one year before exercising the option and then must buy and hold the shares for another year. Provided these conditions are met, all profits are treated as capital gains.
Although non-qualified options lack the tax advantages of qualified options, they also do not have the restrictions. When the market price is right, all the employee needs to do is take the options to a broker and use them to buy the shares and then sell them to collect the profit. If it’s not convenient to raise the cash to pay the strike price, brokers may execute a “cashless exercise.” In that case, the broker charges a moderate fee to lend the money to buy the shares and then recovers the funds by selling the shares, depositing the difference in the employee’s brokerage account.
Qualified options have two disadvantages. First, they must be held for a year, tying up funds that could be invested elsewhere. Second, a more significant issue is market risk. There is no guarantee the stock will not fall in value after the option is exercised, reducing or eliminating potential profit. To guard against this some people purchase put options for the stock on the open market. If the stock does decline the put options will gain value as fast as the stock loses. This is still only partial protection, however, since earnings realized from put options do not qualify for capital gains tax rates.
Non-qualified options are not immune to market risk. Once a non-qualified option exercise is completed, the profits are secure. However, there is always the chance the stock will appreciate further. To safeguard against this, some companies will “reload” an exercised non-qualified option. A new option is issued with the current market price as the strike price but with the expiration date and other terms the same. If the stock does continue to gain in value, the employee can capture those profits as well by exercising the reloaded option.