How Do Employee Stock Options Work?

Employee stock options are a common form of equity compensation, especially among startups and tech companies. Although the benefits of stock options are not as immediate as cash in your hand, stock options have the potential to pay off big, especially if you join a company early enough and it takes off.

To understand the ins and outs of employee stock options, let's go over the basics.

What Are Employee Stock Options?

Stock options aren't shares of actual stock. An employee stock option is a contract that gives employees the right to buy a specific number of shares of company stock at a specified price called the strike price, within a particular time frame known as the exercise window. Although some of the rules that regulate stock options are imposed by tax and securities laws, others are at the company's discretion.

To take full advantage of your stock option offering, you should familiarize yourself with your equity grant agreement before making any decisions or taking any action with your stock options. The grant document is how your company will award equity compensation, and it will spell out the details of your equity plan, including:

• The grant date: the specific date your stock options are granted to you.
• The number of options granted.
• The type of options granted: either incentive stock options or nonqualified stock options.
• Your strike price: the price you will pay to buy the options, also known as the exercise price.
• Vesting schedule: when employees can gain rights to their grant of stock options, incrementally over time or all at once. They can also be awarded on a time-based or performance-based measure.
• The exercise window: employees are able to exercise options only during a fixed period, typically seven to 10 years if still employed.
• The expiration date: the date an option contract expires and can no longer be exercised.
• The effect that termination of employment and a change in the control of the company have on vesting.

Consider this scenario: Let's say you got a job at a new startup, and you are granted 10,000 stock options, vesting over four years. Your exercise (or strike) price is $10 per share. Under the time-based vesting schedule, 25% of your options vest per year over the four years (2,500 options per year). If you remain employed by the company for all four years, you will be able to exercise all of your stock options.

Remember that the option contract gives you the right to buy the shares at the exercise price of $10. Options are valuable only if the stock price increases above your strike price: for example, if the stock price had risen to $15 but you had the option to buy them for $10 each. If the stock price decreases, it's best not to exercise the options and let them expire.

NSOs and ISOs: What's the Difference?

There are two main types of stock options that companies award to their employees: incentive stock options, or ISOs, and nonqualified stock options, or NSOs. The most significant difference between the two is in the tax treatment.

Nonqualified Stock Options

NSOs are also called nonstatutory stock options. When you exercise NSOs, the spread or difference between your strike price and the company's market price is taxed at ordinary income tax rates. The spread is known as the discount or bargain element, and the IRS considers it compensation. For instance, as in the example above, your stock options have a strike price of $10 per share. You exercise them when the price is $15 per share. You have a $5 discount ($15-$10) and thus $5 per share in ordinary income.

Generally, when you exercise NSOs, your employer will withhold taxes: federal and state income tax, Social Security, and Medicare. In order to pay the taxes associated with the exercise, employees may receive fewer shares. When you sell the shares, whether immediately or after holding onto them, the proceeds will be taxed according to capital gains rules.

Incentive Stock Options

ISOs, on the other hand, qualify for special tax treatment. Unlike NSOs, ISOs are not taxable when exercised. Moreover, if held for more than two years from the grant date and one year from the date of exercise, ISOs qualify for the favorable long-term capital gains tax rates. This benefit makes a significant difference as long-term capital gains are taxed at favorable rates (0%-20%) compared with ordinary income, which can be taxed up to 37%.

The AMT Trap

There is another type of tax you should know about if you exercise ISOs: the Alternative Minimum Tax. AMT runs parallel to the regular tax system, and taxpayers calculate both types of tax when figuring out how much tax they will ultimately owe. Whichever calculation yields the higher tax liability will determine the taxes owed. The alternative minimum tax is designed to help ensure that high earners pay at least a minimum amount of federal income tax. (Without getting into the weeds of the AMT calculation, certain credits and deductions awarded under the regular tax calculation are added back to your AMT liability.)

Although ISOs' bargain element is not recognized as taxable income at exercise, it is recognized as taxable income under the AMT calculation. Even though you must report the ISO bargain element as AMT income, it's possible you may not end up paying AMT in the year of exercise. There are key factors determining whether or not you will pay AMT, such as the number of ISOs exercised and the total bargain element. Considering this, it may be worth it to calculate the number of ISOs exercisable without triggering the higher AMT liability.

The $100K Rule

In addition to the holding period requirements, ISOs are bound by additional rules such as the $100K rule. The IRS says that if an employee receives more than $100,000 worth of exercisable incentive stock options in a year, the portion of the grant exceeding the $100,000 limit will be treated as nonqualified stock options.

Making a Plan

Taking a smart approach to stock options involves thinking about your whole financial picture and identifying the goals you have for your money. What do you want to do with the proceeds from the eventual sale of the stock? Understand what you want and need out of life, and then figure out how stock options can play a role in achieving those goals, whether it's starting a business, creating a nest egg, or providing meaningful experiences for yourself and your family.

Samuel Deane is a financial advisor and CEO of Deane Wealth Management, an independent investment advisory firm for millennials in technology. Samuel specializes in comprehensive financial planning, equity compensation, and tax planning. The views expressed in this article do not necessarily reflect the views of Morningstar.