There is no shortage of legendary stories about workers with rich stock options for their employees.
For example, Microsoft (MSFT) reportedly made around 10,000 employees billionaires, not only top executives but also everyday engineers, marketers and support staff who entered early and were detained.
Of course, the potential benefits are clear. But managing employee stock options is not easy. A recent study by ESO funds shows that this process can be challenging.
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Certainly, 67% of former startup employees felt that they were just “somewhat” or “nothing” confident when it came to knowing their fairness, making decisions, and knowing how and when to make options.
Responses from a wide range of experts, from engineers to salespeople, highlight how widespread the widespread confusion can be.
Let’s take a look at what you need to know if employee stock options are part of your compensation.
What are employee stock options?
Just like regular options, employee stock options will give you the right one, but you do not have to be obligated to purchase a set number of company stock at a fixed price. This price is known as the “strike price” or “strike price.”
Typically, the exercise or strike price is fixed to the fair market value of the stock on the day the option is granted.
For example, let’s say you join the XYZ widget and receive 1,000 shares of options at a strike price of $10.
It sounds easy, right? But have you read the detailed print on the vesting period?
Perhaps you won’t be able to buy all these stocks right away.
“Most stock options come with a vesting schedule, meaning you get the right to exercise some of the options over time,” says Aridange, financial advisor at Raymond James & Associates.
“The common structure is a one-year cliff vesting for four years,” explains Dhanji.
Wait a year and assume the stock is $15.
You can exercise 250 vested options for $2,500 at a strike price of $250. If you want to sell stocks for $15 right away, pocket $3,750. You also get a profit of $1,250 before taxes and fees.
Of course, the opposite could also occur. If stock is below the strike price, the options are not worth exercising.
You will be overpaying compared to the market. Therefore, these options are called “underwater.” But everything is not lost. You can hold on and wait for the stock to rebound.
One more thing to keep in mind: Stock options will not last forever. Most have an expiration window of 10 years from the date of grant.
And once you leave the office, that window can shrink quickly – usually up to 90 days after departure.
Missing that deadline, employees’ stock options expire worthlessly.
Types of Employee Stock Options
There are two main types of employee stock options: incentive stock options (ISO) and nonqualified stock options (NSO).
ISOs are provided only to employees and have a clear tax advantage if certain conditions are met. When you exercise an ISO, the difference between the fair market value and strike price of a stock (“spreads”) is not immediately taxed as normal income.
They also do not borrow payroll taxes such as Social Security or Medicare.
However, spreads count as income under the Alternative Minimum Tax (AMT). Even if you haven’t sold your shares, this could mean a surprising tax bill.
To lock in favorable long-term capital gains tax rates, two key retention rules must be met.
1. Hold shares for at least one year after exercise. and
2. Wait at least 2 years from the original grant date before selling
If the sale is too early – before both conditions are met, it is called “disqualification disciplinary”. In such cases, the spread is taxed as normal income, with only additional profits being treated as capital gains.
Suppose you wait two years and have 500 shares of XYZ shares entitled.
You exercise them and pay $5,000. They are ISOs so don’t borrow income tax immediately. However, a $20,000 spread counts as revenue under AMT.
If you own these shares for at least one year and sell them for $70, a $30,000 profit qualifies as long-term capital gains.
However, if you sell previously, the initial $20,000 spread will be taxed as normal income, with only the extra $10,000 being treated as capital gains.
NSOs are more flexible. It can be granted to people who provide services to the company, such as employees, contractors, consultants. But they are taxed differently.
When you exercise an NSO, spreads are treated as normal income. Reported at W-2 for employees or 1099 if not. You will also bear payroll taxes on your income, such as Social Security and Medicare.
When you ultimately sell shares, any gains or losses from holding the shares after that point will be taxed separately as capital gains.
Employee Stock Options Strategy
Given the complexity of taxes and the financial risks associated with it, it is important to seek the advice of a qualified tax or financial advisor when it comes to stock options for customers and employees.
At the same time, you can start thinking about some basic strategies.
“You can exercise your ISO in small quantities to avoid triggering AMT,” said Trevor Ausen, a certified financial planner who runs a genuine Life Financial Planner.
“Every year, many people have a space between their normal taxable income and alternative minimum taxable income (AMTI).”
Then there’s a big picture. When a company’s stock starts to take up more space in its portfolio, concentration risk increases.
Generally, it is wise to ensure that one inventory does not exceed 10% to 20% of its net worth, but the range can vary depending on your goals, age, and desire for risk.
Finally, you need to negotiate the terms of your employee stock options.
“There’s a dollar-value approach,” said Scott Chou, co-founder and managing partner of ESO funds. “Multiply the number of options by the strike price and compare it to the salary.
“Index ventures suggest that four-year equity grants will decline between 25% and 100% of annual sal.”
