A Primer on Employee Stock Option Plans

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To compensate, retain and attract employees, many companies issue stock options.

With an employee stock option (ESO) plan, you are offered the right to buy a specific number of shares of company stock, at a specified price called the grant price, also known as the strike or exercise price, within a specified number of years.

This is not considered an official retirement plan like a 401(k) plan. Employees who are granted stock options hope to profit by exercising their options to buy shares at a price that is higher than the exercise price. Terms of ESOs will be fully spelled out in an employee stock options agreement.

The employee stock option plan should not be confused with an Employee Stock Ownership Plan (ESOP). The ESOP is a retirement plan in which the company contributes its stock (or money to buy its stock) to the plan for the benefit of the company’s employees.

The ESOP maintains an account for each employee participating in the plan. Shares of stock vest over time before an employee is entitled to them. With an ESOP, you never buy or hold the stock directly while still employed with the company. If an employee is terminated, retires, becomes disabled or dies, the plan will distribute the shares of stock in the employee’s account.

The options will have a vesting date and an expiration date. You cannot exercise your options before the vesting date or after the expiration date.

Here’s a summary of the terminology you will see in an employee stock option plan:

Grant price/exercise price/strike price– the specified price at which your employee stock option plan says you can purchase the stock
Issue date– the date the option is given to you
Market price– the current price of the stock
Vesting date– the date you can exercise your options according to the terms of your employee stock option plan
Exercise date– the date you do exercise your options
Expiration date– the date by which you must exercise your options, or they will expire.

Types of options

There are two types of stock options companies issue to their employees:

NQs – Non-qualified stock options
ISOs – Incentive stock options

Nonqualified stock options

These are the stock options of choice for broad-based plans. Generally, you owe no tax when these options are granted. Rather, you are required to pay ordinary income tax on the difference, or “spread,” between the strike price and the stock’s market value when you purchase (“exercise”) the shares. Companies get to deduct this spread as a compensation expense.

Nonqualified options can be granted at a discount to the stock’s market value. They also are “transferable” to children and to charities, provided your company permits it.

Choosing the right moment to exercise is not as easy as it looks. Improperly exercising stock options can cause financial headaches, particularly when it comes to paying taxes on your profits. Even if you keep the stock you purchased, you’ll still have to pay taxes.

A safe way to deal with potential uncertainty in share prices is to take out some cash when you exercise, at least enough to cover the tax bill.

An even more conservative way to deal with stock options is to view them exactly the way the IRS does: as income. When exercise, take 100% of your profits in cash — don’t hold onto any shares. Then, manage that money as you see fit.

Incentive stock options

These are also known as “qualified” stock options because they qualify to receive special tax treatment. No income tax is due at grant or exercise. Rather, the tax is deferred until you sell the stock.

At that point, the entire option gain (the initial spread at exercise plus any subsequent appreciation) is taxed at long-term capital gains rates, provided you sell at least two years after the option is granted and at least one year after you exercise.

ISOs give employers no tax advantages and so generally are reserved as perks for the top brass, who tend to benefit more than workers in lower income tax brackets from the capital gains tax treatment of ISOs.

High-paid workers are also more likely than low-paid workers to have cash to buy the shares at exercise and ride out the lengthy holding period between exercise and sale.

If you don’t meet the holding-period requirements, the sale is ruled a “disqualifying disposition,” and you are taxed as if you had held nonqualified options. The spread at exercise is taxed as ordinary income, and only the subsequent appreciation is taxed as capital gain.

Unlike nonqualified options, ISOs may not be granted at a discount to the stock’s market value, and they are not transferable, other than by will.

Two warnings:

No more than $100,000 in ISOs can become exercisable in any year.

The spread at exercise is considered a preference item for purposes of calculating the dreaded alternative minimum tax (AMT), increasing taxable income for AMT purposes. A disqualifying disposition can help you avoid this tax.

An employee stock option plan will have a plan document that spells out the rules that apply to your options. Get a copy of this plan document and read it,

Grantees should hire a retirement planning expert that is familiar with these types of plans to assist you.

There are many risks involved with ESPs like investment risk, tax planning, and market volatility, but the most important factor is your personal financial circumstances, which may be different than those of your co-worker.

Keep this in mind before following anyone’s advice.

A Primer on Employee Stock Option Plans

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