Author: Randy Joseph, CPA
Some companies offer various types of stock benefits, but the most common today are stock awards and restricted stock unites. In fact, you may already have some kind of stock option from your employer right now. Let’s explore the basics of what those options are – and more importantly, how you can make the most of them.
Stock options: The basics
An employee stock option grant gives you the right to buy a specified number of company shares at a specific price (sometimes called strike price) within a specified time period. Usually there is an expiration date as well for when you can purchase those shares as well.
There are a few key terms to understand:
Vest means that certain shares are available to exercise
Exercise means to purchase
Spread is the difference between your price per share according to the grant document and the fair market value on the date you exercise the shares
Qualified vs. Non-Qualified Stock Options
In general, there are two kinds of stock options given to employees:
Qualified Stock Options (also called Incentive Stock Options or ISOs)
Non-Qualified Stock Options (NQOs)
With both kinds of options your grant document will specify a price per share should you decide to exercise (or purchase) these options. It’s important to know that the strike price is set, but if you decide to buy the options the fair market value is likely higher than that original strike price. In that case: you’re getting a bargain! If the fair market value isn’t higher than the strike price, you may want to hold off on purchasing those shares just yet.
The spread between the strike price and the price in the market the day of exercise is taxable depending on the kind of stock option. The two types of options differ greatly in how this spread is taxed and when.
When you exercise your ISOs you pay the purchase price per the grant document, but you do not pay federal income tax at that time. The mere purchase of an ISO is not a taxable event for regular federal income tax; however the spread is taxable for alternative minimum tax (AMT) purposes, meaning that the spread between your strike price and fair market price will be included as income for AMT purposes.
ISOs also get a bit tricky since the AMT calculated in the year of purchase can generate an equal AMT credit that may be given back to you in the future. In order to ultimately get long-term capital gains treatment when you sell, you have to hold those shares for at least one year after exercise and two years after the grant date. If you follow the rules of the grant document (and IRS tax code) and the market does not drop, you will get long-term capital gain treatment on the spread. It can be complicated though because you have to pay AMT up front in the year of exercise, wait until the holding period is over, and then sell. If all the pieces are in place, you would get your AMT back and pay only long-term capital gains on the spread. If you don’t follow the rules laid out in the grant document and/or the market price drops, you could end up owing taxes on stocks that are valued way below what you paid for them.
If you have this type of option, I’d strongly advise that you work with an investment or tax advisor to maximize the potential of your shares and avoid any potential pitfalls.
NQOs tend to be more common than ISOs and are simpler. When you exercise these options the spread between your strike price and the fair market value that day goes into your W2 and is taxed as ordinary income.
Practical tips for exercising your shares
When your stock vests and you choose to buy some shares, you must pay the price of the stock and you must also pay in taxes to the IRS (for NQOs). You have a few options for how you pay – you can take money out of your bank account and send it to your company brokerage firm, or you can do a same-day sale to cover those costs. In the case of a same-day sale, or a “sell to cover,” the moment you exercise the shares the brokerage firm sells off just the right number of shares to pay for your shares and to pay for withholding of federal taxes.
It’s important to note that in most cases the federal income tax is not sufficiently met by a “sell to cover.” Most companies have a default 22 percent federal income tax withholding (in addition to social security and Medicare tax) – that default percentage may not be enough depending on your income tax bracket. In those cases you could end up owing additional taxes and penalties for not having paid in enough during the year.
With a few exceptions, companies will not move off this 22 percent default. Therefore, employees must augment their tax withholdings either with an estimated tax payment at the time of exercise or by increasing their withholdings on their regular salary to cover.
Keep your documents handy
We always ask new clients to send us their grant documents, which lay out the rules according to the Internal Revenue Service code. These contain a wealth of information including price, exercise vesting schedules, and rules for the entire process. We ask for other documents as well, such as annual statements from the company detailing what shares you have exercised and what you still have left for the future. We also look at confirmation reports when you do exercise, as well as the brokerage statements showing any sales to cover or other sales of the stock. A good tax advisor will always ask for these documents to get the complete picture.
Create a folder that is secure but easy for you to access and put all the grant documents in this folder. Make a subfolder for each year and keep track of your confirmations and brokerage statements for that year. That way when your tax advisor asks you for information about your stock options you can quickly send it on.
I can distill the above to a few quick, but important points:
1. All stocks are risky. Diversify your holdings. Beware particularly of ISO rules and risks.
2. Make sure you are paying in enough tax when you exercise non-qualified stock options. The default 22% is often not enough.
3. Organize your stock option documents in one easy to fine place.
4. Stock options are complex. Seek advice when needed.
This may seem like a lot of information to absorb, but with the help of a trained tax or investment advisor you can feel more confident about your options – and learn how to get the most out of them.
In 1988, Randy Joseph started her own tax firm in downtown Seattle. Over the years it grew to over 800 individual tax clients as well as many trusts and corporations. In 2011, she sold it with the intention of doing more art, community activism, and spending more time with her family.
But Randy’s daughter Deva had a different idea… a request that Randy pass the baton and teach her tax. Ever entrepreneurial (and apparently not at all ready to retire), Randy was thrilled and opened a new firm to teach Deva with real-world experience. Deva and Randy became partners and renamed the firm Joseph & Hetrick LLC.
Having a boutique firm fits their style perfectly. With just the two of them, this close working model allows them to know clients deeply; finances, dreams, goals and challenges. To connect with Randy and Deva, visit Joseph & Hetrick LLC.
About Money & Mimosas: Money & Mimosas was started as a passion project by Danetha, a former NFL cheerleader turned entrepreneur and financial journalist. After a brunch conversation with girlfriends, Danetha was inspired to launch a blog to explore her journey of becoming rich, sexy and confident.