Stock options are valuable employee fringe benefits if the company is healthy and successful. By cashing in these options, employees stand to earn a considerable lump sum, with very few restrictions.
A stock option is the option to buy a company’s stock at a set price. Typically, the company offers to freeze a certain number of stocks at the current market price for a period of time. The idea is that the stocks will rise in value over time. For example, if a company has granted an individual the option to purchase 1,000 shares at $5 each (the grant price), and the market value of the stock rises to $15 per share (the exercise price), the individual can earn $10 per share, or $10,000. The two different types of stock options are incentive stock options (ISOs) and non-qualifying stock options (NSOs).
Incentive Stock Options
An incentive stock option (ISO) is only offered to employees of a company. Some restrictions apply in order for the employee to obtain the tax advantage of ISOs. For example, the employee must hold the stock for one year. Only the first $100,000 of the grant price of the options are considered ISOs. The price of the shares must have risen by the date of purchase, and the option must be used by a ten-year expiration date. “Vesting,” or requirements that must be met for exercise of the stock option, also applies. For example, the contract may state that 25 percent of the options vest each year for a period of four years. This prevents the employee from exercising all his options at once.
Non-Qualifying Stock Options
A non-qualifying stock option (NSO), so named because the optionee doesn’t qualify for an ISO, can be given to directors, consultants, customers or anyone else the shareholders wish to compensate. A portion of an employee’s ISO can become an NSO if he fails to meet limitations outlined in the contract.
Exercising the Stock Option
The optionee doesn’t necessarily need to have available cash to purchase the shares included in a stock option contract. Two types of cashless exercises exist: a same-day sale and a sell-to-cover exercise. A stock broker can implement a same-day sale, in which the shares are bought and sold virtually simultaneously, or a sell-to-cover exercise, whereby the shares are sold to cover the exercise price. Of course, the optionee may simply pay cash for the available shares, or he may choose to exchange stocks he currently owns.
No taxes are owed simply because stock options have been granted. Of the two types of stock options, the ISO offers the most favorable tax implications. The individual who exercises an ISO may defer taxes until the date that he sells the shares. Even then, the tax is viewed as capital gains, instead of income tax. When an optionee exercises an NSO, it is immediately taxable as compensation, and the employer must withhold payroll taxes as well. The best tax scenario regarding an NSO is if the optionee holds the stock for more than a year. It is still considered compensation, but the profit from the sale is taxed on a capital gains basis, which is typically lower than the income tax rate.