How Do Employee Stock Options Work?

Many employees have a benefit they may not be aware of, or may not fully understand. I’m referring to employee stock options. Employee stock options, also referred to as company options, are a call option.

If you are familiar with stock options trading, you will understand that to be an option to buy a stock at a set price within a set time period.

Depending on your company, the strike price, and other factors, these stock options may be a wonderful benefit, or essentially worthless. Let’s take a look at company stock options to answer a few questions, such as what they are, how to value them, and whether or not they are a good investment opportunity for you (and if they are, what you can do with them!).

This article focuses on employee stock options, specifically:

• What are stock options?
• Why do stock options exist?
• Why do employers offer employee stock options?
• Benefits of employee stock options (ESOs)
• Types of employee stock options
• Company stock option vesting periods
• What Employees can do with company stock options
• Should you exercise employee stock options?
• Tax treatment of employee stock options

What Are Employee Stock Options?

As you most likely already know, a stock is an ownership in a company.

A stock option is simply a contract that allows you to purchase or sell shares of stock (usually in blocks of 100 shares), for a certain period of time, for a certain price.

If, after that time, the owner has not exercised the option, it expires and is worthless. You can buy stock option contracts through most online brokers.

When a company offers stock options to its employees, it is offering them an opportunity to purchase ownership in their company, usually by offering employees the opportunity to buy a specified number of shares of their employer’s stock within a set time period and at a price established by the company.

This can present a great buying opportunity for employees if the strike price is lower than the current market price or can make the company stock options essentially worthless if the strike price is substantially higher than the market price.

For example, someone might own a Microsoft call option contract (call options are options that allow you to purchase stock at a predetermined price). This contract might call for the right to purchase 100 shares of Microsoft at $25 per share.

If Microsoft’s stock price is above $25, the option has intrinsic value, or ‘in the money.’ If the stock price is equal to $25, the option is said to be ‘at the money,’ and if it is less than $25, the option is ‘out of the money.’ In the last two cases, the option does not have intrinsic value.

Why Do Stock Options Exist?

Stock options exist primarily because there are people who want to use leverage to expand their possible returns. Using the above example, you could either purchase Microsoft stock directly. This would cost $2,500 (plus trading fees).

At this point, you now have a position in Microsoft stock. You receive all the dividends that Microsoft issues. However, any changes in stock price directly impact your stock’s value.

In this case, if your stock’s value declines, your position actually goes down. If you sell at this point, you would lose the difference between what you paid and what you sold it for.

Conversely, you can purchase an option at approximately its intrinsic value (plus trading fees). The cost of the option would depend on the cost of Microsoft’s stock at the time of purchase, and how much time remains until the option expires.

While this calculation is too complex for this article, we can safely assume that this cost would be considerably less than $2,500. Having an option allows a few more options, depending on the stock’s direction:

• If the stock appreciates in value, you can exercise the option & own the stock. You can even sell the stock immediately after you exercise the option and pocket the difference (minus taxes).
• If the stock appreciates in value, you can sell the option to someone else. In this case, you would still make a profit. However, that profit would only be the difference between the purchase price & sale price of your option, not the stock itself.
• If the stock loses value & the option expires worthless…you can walk away.

The last part is key…investing in an option allows you to use leverage in order to participate in stock gains without taking the full risk of owning the stock itself. While there are various pros and cons of owning stock options, this is where we transition to employee stock options.

Why Do Employers Issue Stock Options?

Employers offer a variety of benefits in order to compensate, attract and retain talent that supports their organization’s goals. When a company grants employee stock options (ESOs), they’re likely trying to appeal to people who:

• Want to share in the company’s long-term success
• Feel as though they are a powerful contributor to that success

Offering employee stock options give workers buy-in to the company and a vested interest in maintaining high job performance. Stock options are also offered as a form of compensation to skilled employees in an effort to go above and beyond a salary.

Some startups and small companies often use stock options as a way to attract talent while allowing them to hang on to as much money as they can.

Additionally, ESOs allow employees to use the power of leverage to avoid putting a significant amount of their own money into the company’s stock. Instead, ESOs are usually kept in a separate account, known as an employee stock option plan (ESOP). This should not be confused with employee stock ownership plans, also known as ESOPs.

There are a couple of differences between ESOs and traded stock options:

• ESOs are usually not traded on any exchange. Since they are a contract between employer and employee, ESOs are usually set aside for the employee’s benefit only.
• There usually are restrictions on when employees can exercise ESOs.
• Tax treatment. Since ESOs are a form of employee compensation, there are different tax treatments for ESOs. This tax treatment depends on the type of ESO.

Benefits of Employee Stock Options

Employee stock options can benefit both the employer and the employee. Many employers offer company stock options at a fixed strike price, based on the stock value on a predetermined calendar date or based on other criteria.

For example, an employee may have the option to buy shares at the stock price at the close of trading on the first day of the company’s fiscal year or some other predetermined date. Some companies even offer employees to buy stock options at a discount of the stock price on a predetermined day.

The goal is the share price will eventually increase and enable employees to sell the stock at a later time, yielding a profit.

Of course, there is also the risk. The downside to stock options is the possibility of holding stocks that do not perform very well, or in the worst case scenario, the company folding and being left with worthless stock.

What Types of Employee Stock Options Are There?

There are two types of ESOs: statutory, and non-statutory.

Statutory stock options are sometimes also known as incentive stock options (ISOs) or qualified stock options (QSOs). Statutory stock options qualify for preferential tax treatment for employees. However, this preferential tax treatment is complex and does require some hurdles, specifically regarding holding periods.

We’ll get to this later. The Internal Revenue Code and IRS Publication 525 (Employee Compensation) contain detailed information on what constitutes a statutory stock option.

Non-statutory stock options are also known as non-qualified stock options (NSOs). NSOs are any stock options that do not qualify as a statutory stock option. This sounds fairly obvious.

However, it’s important that there are two ways this can happen. The first is if a company specifically grants an ESO as a non-qualified stock option. In other words, that was the company’s intent.

The second is if the company grants an ISO that fails to meet the qualifying criteria for preferential tax treatment. This most likely happens when the underlying stock is disposed of without meeting the holding requirements and is known as a disqualifying disposition.

What is Involved with ESOs?

There are three things that impact the tax treatment of ESOs.

• Grant date. This is when the employer grants the options to the employee. At the time of grant, the employee only has the option to buy stock, not the stock itself.
• Exercise date. This is when the employee has decided to exercise the option to purchase the stock itself.
• Sale date. This is when the employee has decided to sell the stock.

Company Stock Option Vesting Periods

A vesting period is the terms of when an employee is allowed to by company stock. Typically, a company will space out the vesting period over a period of several years, allowing employees to buy only so much in shares for each year.

Example: Let’s say an employee is offered 100 shares of stock in the company. The vesting schedule at the company is spaced out over a four year period. During the first year, the employee will be one-fourth vested, meaning they can purchase 25 shares of stock each year until they become fully vested after the fourth year.

The vesting period may vary for each company, with some companies requiring employees to work for the company for several years before they are eligible to purchase employee stock options.

What Employees Can Do with Company Stock Options

Employees with stock options have various ways to utilize their stocks including:

• Convert and Sell – An employee can purchase the discounted shares, convert the options into stock and then sell all stocks after the required waiting period has ended.
• Sell and Keep – An employee can purchase the discounted shares and after the waiting period has ended, they can sell some of the stock they have immediately but keep the remaining stock to sell at a later date should the price rise in the future.
• Sell Later – An employee can purchase all options and convert them into stock. They can continue to hang on to the stock and watch pricing with the intent to sell in the future if and when share worth has increased.

Transferring Your Stock

If you were ever to leave a company the vested portion of your stock options are yours to keep. This means if you have converted your stock and plan to hold on to it you should look at moving it to a brokerage account.

Some top online brokers to consider are:

Ally Invest

Ally Bank eliminated commissions on stock and ETF trades, making investing with Ally Invest one of the least expensive ways to purchase stocks on the market. You can learn more in our Ally Invest review.

Start an account with Ally Invest >>

TD Ameritrade

Known for being the cheapest major brokerage to purchase ETFs, TD Ameritrade is more than capable of helping you transfer your stock. See more details about this brokerage in our TD Ameritrade review.

Start an account with TD Ameritrade >>

E*Trade

One of the first online brokerage accounts, E*Trade is now a well-respected stockbroker. Since they are a full-service brokerage you can use your stock in a variety of accounts, including retirement. Learn more about them in our E*Trade review.

Start an account with E*Trade >>

Should You Exercise Employee Stock Options?

Company stock options come with a certain amount of risk. For example, most financial experts recommend not to buy too much company stock. You should also be aware of your timeline because options have an expiration date.

It is important to monitor the stock price leading up to the expiration date so you have a better idea of the value of your employee stock options.

If you receive employee stock options at a reasonable strike price and can make some money, it may not be a bad idea to exercise your options then cash them in immediately so you don’t have too much of your portfolio in your company’s stock.

Keep in mind there will be tax implications if you make this move, so it will be a good idea to speak with a financial professional to better understand the financial implications of such a move.

What is the Tax Treatment for ESOs?

Tax treatment is the primary difference between NSOs & ISOs. Since NSOs are simpler, we’ll cover them first:

NSO tax treatment for the employee

Upon grant, the employee may be subject to ordinary income tax. Whether or not there is taxation upon NSO grant depends on whether there are restrictions on the employee’s ability to exercise the NSO, and whether the exercise price is less than the stock’s market price at the time of grant.

More information can be found in Section 409A of the Internal Revenue Code, under Nonqualified Deferred Compensation.

Upon exercise, the employee is subject to ordinary income tax (not capital gains tax) on the difference between the option price and the stock price when the option was exercised.

For example, an employee holds options to purchase 1,000 shares of Microsoft at $25 per share. Microsoft stock is currently $40 per share. If the employee exercises these options today, he or she would be subject to ordinary income on the difference ($15 per share, or $15,000).

This difference is also known as the bargain element. The employer is also required to withhold all applicable taxes on NSO exercise, just as if it were normal pay.

Upon sale, the employee would be subject to normal rules surrounding the sale of stock. Sales of stock owned for a year or less are considered short term capital gains or losses.

Short term capital gains & losses are netted out with long term capital gains & losses on Schedule D of your tax return. Any remaining short term capital gains are subject to ordinary income tax.

NSO tax treatment for the employer

Upon employee exercise, the employer is eligible to deduct the full bargain element as employee compensation. From the employer’s point of view, this essentially is employee compensation.

It’s understandable why most employers prefer to issue NSOs over ISOs—NSOs allow for simplicity & better tax treatment for employee compensation.

ISO tax treatment for the employee

1. ISOs have no ordinary tax implication during grant or exercise. However, ISOs are a preferred tax item for calculating alternative minimum tax (AMT).
2. Gains attributed to ISO stock sale are calculated at long-term capital gains rates. This is due to the holding period requirements for an ESO to remain an ISO.
3. Holding period requirements.
   1. Shares must not be disposed within two years of the ISO grant date or one year of the ISO exercise date. The fact that ISOs must not be sold within 1 year of exercise date automatically confers long term capital gains (or loss) treatment on any ESOs that remain ISOs.
   2. However, ISOs must be exercised within 3 months of an employee’s departure from the company (or 1 year if separation is due to a disability).
4. ISO Example:
   • January 10, 2015- share value is $10: company issues an option to purchase 1 share of stock with a strike price of $10.
   • January 11, 2016- share value is $50: employee exercises the option and pays the company $10 to purchase 1 share of stock.
   • January 12, 2017- share value is $100: employee sells the share for $100. The employee has $90 of gain that is treated as a long-term capital gain.

ISO tax treatment for the employer

Employers receive zero preferential tax treatment for the proper grant, exercise, or stock sale of an ISO. However, any stock sales that are deemed disqualifying dispositions change an ISO to an NSO.

In that case, the employer can take all applicable tax deductions as if it had granted an NSO.

Employee Stock Options – Two Examples

I recently was talking with a friend who had received ISOs through her employer. At the time she received her ISOs, her employer was a start-up, and ISOs were one of the main reasons she came to work at the company.

Fast forward 18 months. The company, which was doing better than expected, got bought out by a larger firm.

As a result, all employee stock options were redeemed, and the employees’ stock was subsequently purchased from the employees. Although this was due to no fault of my friend, this transaction effectively transformed her ISOs into NSOs.

As a result, she must realize ordinary income on the entire value of the option. Not only that but because the stocks were sold immediately after the options were exercised, she must realize ordinary income on the appreciation of the stock.

This normally would have qualified for preferred tax treatment as capital gains had they remained ISOs.

Another example: Ryan Guina, the founder of this website, mentioned he previously worked for a company that offered employee stock options. He was awarded 500 company stock options at a strike price of near $10.

However, the market price at the time he was eligible to redeem the options was around $4 and falling. He mentioned the company later folded. Needless to say, this is an example of a worthless stock option!

Leaving Your Employer? Consider Rolling-Over Your Investment

Job changes happen frequently, and they are becoming even more common among younger generations. Few people remain at their first employer for 40-years anymore.

When an individual leaves one employer, he/she must make the decision to leave the money he/she invested in the previous employer’s retirement account and not touch it, or roll that money over into another brokerage account.

Every situation is different, and each investor must consider which option is best for them. However, should you consider rolling your retirement over into a new account, a few reputable brokerage firms to consider include Ally Invest, E*Trade, and Zack’s Trade.

Conclusion

While many job seekers might not find jobs that grant ESOs, there are companies that do award them. When shopping around for compensation packages, it definitely pays to understand what type of stock options you might be eligible for and to have a better understanding of how to maximize their benefit.

If you have a concern about how your employee stock options might affect your financial situation, you should contact a fee-only financial planner who can help you figure out what’s right for you.

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