Non-Qualified Employee Stock Options

Stock options tie key employee fortunes to company stock.

Corporate America provides incentives to key employees through the use of non-qualified employee stock options. Non-qualified employee stock option compensation programs align the business interests of the company with key employees through the grant of options to purchase company stock in the future at a predetermined price. The stock grants have expiration dates that are usually two to five years from the date granted. As the company stock price rises above the option strike price, employees receive additional compensation from their company's growth when the option is exercised. There are three stock option exercise strategies to consider -- exercise and sell; exercise, sell and hold; and exercise and hold -- which can be executed with the help of most brokerage firms.

Exercise and Sell Strategy

The exercise and sell strategy results in no shares held in company stock by the employee. The employee receives the difference between the stock market price and the employee stock option strike price on the date exercised, times the number of shares exercised. For example, if the company stock trades at $40 and the stock option strike price is $5, an employee would receive $35,000 for the exercise of 1,000 shares. This gross amount of $35,000 would be subject to taxation as earned income.

Exercise, Sell and Hold Strategy

The exercise, sell and hold strategy results in the sale of enough shares to cover the expense to exercise the remaining shares to be held in company stock by the employee. Assuming the facts in the above example, the employee would need to generate $5,000 to pay for the exercise of 1,000 shares with a $5 strike price. The sale of 125 shares of company stock at the market price of $40 would generate the needed cash with the remaining 875 shares of stock held by the key employee. The market value of $35,000 for the remaining shares represents the gross amount of compensation received upon completion of the transaction and is subject to taxation as earned income.

Exercise and Hold Strategy

The exercise and hold strategy results in the use of borrowed funds to pay for the costs to exercise the employee stock options, which results in holding all of the company stock exercised by the employee. In our example, $5,000 would be borrowed to pay for the cost of the option exercise and the 1,000 shares of company stock would be held as collateral for the loan. The net value of the portfolio of $35,000, market value minus stock loan, would be subject to taxation as earned income.

Investment Considerations for Exercise Strategies

The investment considerations for the different non-qualified stock option exercise strategies are related to taxes and overall risk. The option exercise strategy examples discussed above do not calculate the actual taxes due upon exercise because each individual has different tax rates based on personal circumstances. The subsequent sale of company stock after an option exercise is treated as a capital gain or loss depending on the price when the stock is sold. For holding periods over 12 months, the capital gains are taxed at the more favorable long-term tax rate. Employee stock option plan participants should avoid accumulating too much of their retirement assets in company stock because of the financial exposure to the fortunes of their company.

References

• IRS: Stock Options