Determining A Stock Option Strategy
Many of our clients at Refresh Investments receive stock options as a portion of their compensation. They want to understand how this impacts their financial situation and create a strategy to capitalize on the opportunity. If you are in a similar position, it’s important to understand certain foundational concepts before taking action.
Whether you’re at a pre-IPO start-up, a growing public company, or a blue chip that just developed a life-saving vaccine, stock options can provide a boost to your current and long-term wealth.
The concept is relatively straightforward, but like everything else, the devil is in the details. Maximizing your profit is just one side of the equation – taxes are also a consideration, and the rules are complex. This short read will arm you with enough information to get you started on sorting out your situation.
When it Comes to Stock Options, Start with the Basics
When you receive stock options, the company does not hand you shares of stock right away. Instead, you receive the right to purchase shares of company stock at a certain price, in most instances below market value. Hopefully, the shares’ price will rise over time, enabling you to sell them at a higher price than when you exercise the options.
When you exercise your stock options, you can purchase shares of your employer’s common stock at the price indicated in your option grant. The "spread" is the difference in value between the strike price and the shares' value when you exercise your options. However, you are not obligated to exercise your options.
Before you can exercise the options or purchase the shares, the stock must first vest, meaning you have to work for the company for a certain amount of time to obtain those shares. In some instances, you may be able to exercise your options early, i.e., before they vest. That move can have tax advantages, but there are downsides as well. You may be prohibited from selling shares of your stock to purchase the vested shares, so you’ll have to shell out your own money.
Stock options can be the more common non-qualified stock options (NQSOs) or incentive stock options (ISOs), which provide tax benefits but also can trigger the complications of the alternative minimum tax (AMT). For example, incentive stock options enable employees to convert part or all the potential stock earnings into capital gains if they hold on to the stock for a certain period.
Some Key Questions
How do I exercise my stock options?
Exercising stock options means buying shares of your employer’s common stock at the price specified in your option grant. Your company may have an agreement with a brokerage company to execute these stock purchases. Once you own actual shares, you do not have to sell them immediately. You are also not required to exercise your options.
How much time do I have?
If your company does not offer early exercising, you can only exercise options once they are vested, which varies from company to company.
What should I consider when deciding whether to exercise?
Are the options in-the-money or underwater? If they are underwater (trading below your exercise price), it may be prudent to wait for the stock price to rise.
Is your company public? If your company is private and does not have plans for filing an IPO in the near term, exercising your options may be risky because you are purchasing shares that may not become liquid. If your company has not yet launched an IPO, you must purchase shares in cash.
Will you have to pay taxes? Depending on your situation (what kind of options you have, the number you were granted, and your compensation, etc.), you may have to pay taxes when you exercise.
When should I sell my shares?
After exercising your options, you may want to consult with a financial advisor and a tax advisor to discuss the most advantageous and profitable manner to sell the stocks. The type of options you have and your holding period after exercising your options will significantly impact your tax liability.
Non-Qualified Stock Options (NQSOs)
NQSOs are the most common type of stock options. Most companies typically choose to hand out non-qualified stock options to employees for tax reasons: they can deduct the costs of NQSOs as an operating expense sooner than with other options. Unexercised NQSOs can be passed on to others, i.e., in divorce or as gifts. In addition, the IRS does not limit the total number or value of NQSOs that a company can grant to an employee.
If you make money when you exercise your shares (i.e., your strike price is lower than current market price), this is considered ordinary income and will be reported on your IRS form W2 for the year you exercised the options.
Once you receive the shares, you have the choice of either selling them or holding on to them. At this point, they are like any other stock investment and will subject to capital gains tax.
Incentive Stock Options (ISOs)
There is a limit on the total value of ISOs that can vest and can be exercised in any calendar year ($100,000), and you cannot transfer them to other people like the NQSOs. Taxation can be more advantageous if a strict schedule is adhered to. You’ll need to hold onto the shares for a minimum of two years from the grant date and one year from the exercise date to qualify for long-term capital gains. If your company is pre-IPO, this can take some careful planning to keep lock-up periods in mind.
ISOs can also subject you to the alternative minimum tax (AMT), which is higher than your normal taxes. The AMT is adjusted based on the price you pay for the shares (the strike price) and the fair market value when you exercise. Because you can choose when to exercise, you do have some flexibility in avoiding or minimizing AMT, but it requires careful planning of your income. A financial advisor or tax professional can usually help you model out various scenarios to select the right one for your situation.
The Bottom Line
Stock options aren’t quite the proverbial “holy grail” of wealth, but the process of effectively including them in your wealth plan can seem as arduous as a quest. Having a trusted financial and tax advisor can make the journey much safer.
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