In the start-up frenzy of the dot-com era, many cash-challenged companies offered employees a piece of the future in lieu of current payroll or cash bonuses. That piece of the virtual profit pie – a stock option –had long been a method of compensation or bonuses for high-place executives.
Stock options may be one of the sole survivors of the dot-com crash. According to the National Center for Employee Ownership, 10 million American employees now have stock options, compared to just 1 million in 1992. An estimated 20-25 percent of public companies offer options to the majority of their full-time employees, and a few offer them to part-timers as well.
A stock option grants an employee the right to purchase a specific number of shares in the company at a fixed price (also called the grant price) for a specific number of years. If and when the share price increases, the employee can exercise (or purchase) the stock at the lower fixed price, then sell it at the current market price, realizing a gain.
Stock options may be nonqualified (meaning it does not receive special tax treatment under the IRS code) or incentive (which do qualify for special treatment). When you exercise nonqualified stock options and then sell them, the gain is taxable as ordinary income. The issuer, which gets a tax deduction for the same amount, can issue as many nonqualified stock options as it wants to employees, officers, directors, consultants and vendors.
Incentive stock options can be issued only to employees and usually must be exercised within three months of leaving the company. The grant value of incentive stock options issued in a year cannot exceed $100,000. If you wait two years to exercise the options and then hold the purchased stock for at least one year, you receive favorable treatment for long-term capital gains tax on all the appreciation over the exercise price. Exercise of incentive stock options and sales of the stock may have alternative minimum tax implications.
Because realized gains from stock options and the valuation of unexercised options that have had unrealized gains can be complex, you should seek the help of a tax advisor, particularly regarding incentive stock options, which can trigger the alternative minimum tax. Calculating tax impact also can provide guidance on when to exercise options, as taxes may take a considerable cut from your profits. Staggering exercises and sales over a period of time can spread the tax burden over several years.
Your financial goals for proceeds from stock options, the amount of time remaining to exercise them, your portfolio’s concentration in your employer’s stock and tax issues all come into play in determining the best time to exercise options. A financial advisor can help you calculate these factors to take some of the mystery and emotion out of exercising