Tax and Financial Strategies For
Employee Stock Options
Introduction
Employee stock options have become a common component of compensation. In fact, they can become the most significant component of your compensation. On the other hand, they can become worthless if the stock price declines below your exercise price. There are also income tax implications to be considered. If you are granted an option, your goal should be to maximize the after tax gain over the long run. But there are many factors to consider in deciding when to exercise and sell your shares.
Factors to Consider
Expectations regarding the future market value of your employer’s stock – This is the most difficult factor to deal with because you are projecting what will happen in the future. However, if you work for a company which has seen substantial appreciation in its stock price, you should consider taking some money “off the table”. If you work for a mature company with continued growth expectations, you may be more confident in adopting a long term strategy in handling your options. Also, you may wish to take some money “off the table” to diversify your investments.
Income tax considerations – An overview of the current rules regarding the income taxation of employee stock options is discussed below. The key tax consideration deals with the rate of tax you will pay on your gain (ordinary income rates versus capital gain rates). Ordinary Federal income tax rates can be up to 35% while long term capital gain rates are generally 15%. The other tax consideration involves the alternative minimum tax which can be triggered by the exercise of Incentive Stock Options (ISO’s).
Cash flow considerations – You will need to have sufficient cash to pay your option price at the time you exercise your shares. You may also need cash to pay income taxes which can be incurred at the time of exercise. If you do not have available cash or do not desire to use your existing cash, you can enter into a same day sale and, in effect, cash in the gain on your option at the time of exercise.
Taxation of Employee Stock Options
There are two types of stock options – Incentive Stock Options (ISO’s) and Non Qualified Stock Options (NQSO’s). ISO’s have more favorable tax opportunities than NQSO’s. If you are holding both ISO’s and NQSO’s and are contemplated a same day sale of a portion of your shares, you should sell your NQSO’s first to maximize the capital gain treatment in the future.
Taxation of NQSO’s - When you exercise an NQSO, you are taxed on the spread between the option price and the market value of your shares at the date of exercise. You pay income tax at ordinary rates on this spread whether you sell your shares or hold them. This is considered compensation and is also subject to payroll taxes (eg FICA and Medicare). Future appreciation is taxed at capital gain rates (generally 15% Federal rate) if you hold the shares for more than one year from date of exercise.
Taxation of ISO’s - ISO’s are not subject to regular income tax at the time of exercise. You will be able to receive long term capital gain rates on your entire gain if you sell your shares at least one year after they are exercised and two years after grant date. However, you may incur Alternative Minimum Tax (AMT) if ISO’s are exercised and not sold in the same tax year.
Alternative Minimum Tax (AMT) – AMT is an extra tax you pay in addition to the regular income tax. The amount of AMT you pay depends on whether you have tax preference items or certain types of deductions. The exercise of an ISO can trigger AMT. The spread between the option price and market value on the date of exercise is considered a tax preference item for purposes of calculating AMT. If you pay AMT in the year you exercise your ISO, you can receive a credit against your regular tax in future years. In some circumstances, AMT is simply a prepayment of tax which is recovered at the time you sell your shares or in other future years. Effective January 1, 2008 you can claim a refundable credit for long term unused minimum tax credits subject to certain limitations.
Strategies for Managing Your Options
Same day sale - Exercising your options and selling them immediately has the advantage of providing cash to pay the exercise price and taxes on the gain. This strategy is appropriate if you believe the stock price has peaked or you want to diversify your investments. You will pay income tax at ordinary rates but do not have to worry about AMT. If you hold NQSO’s, it is generally best to do a same day sale because you will be taxed at the time of exercise even if you hold the shares.
Exercise all and sell a portion of your shares immediately – This is often the optimum strategy because it provides cash to pay the option price and taxes but enables you to hold some shares for future appreciation and capital gain treatment. If you hold both ISO’s and NQSO’s, you can sell all or part of your NQSO’s which would be taxed upon exercise in any event and hold your ISO’s for over one year to obtain capital gain rates. If all of your options are ISO’s, this strategy can be implemented by selling a portion of the shares at the time you exercise and holding the balance of your shares for the long term. You can also minimize AMT by using this approach.
Stagger your exercise dates over several years – This works well if your options are all ISO’s because you will minimize your chances of incurring AMT. In fact, a calculation can be made to determine the maximum number of shares to exercise each year without triggering AMT.
Exercise early and hold shares for long term appreciation - If you have vested options and the spread between the option price and the market value is small, you may minimize income taxes by exercising sooner rather than later. Although this strategy has tax advantages, it may not make economic sense. One of the advantages to holding employee stock options is that you benefit from appreciation without risking any investment. If you exercise before any significant appreciation occurs, you defeat this advantage. Therefore, many people prefer to wait until the stock price has risen before they exercise so they are not risking any cash investment. Once you exercise, you are exposed to a loss if the stock value declines.
83b election – If your employer allows you to exercise subject to forfeiture, an 83B election can be very favorable. This is generally applicable if you exercise shares before you are vested and the spread between the option price and market value is small. This often occurs in start up or pre IPO companies.
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