Many companies use employee stock options (ESOs) to attract, retain, and motivate their employees. According to the National Center for Employee Ownership, about 36 percent of the workforce owns shares in their employing company’s stock. ESOs can be a good investment, but they are more complicated than traditional stock market investing. In this week’s post, we will take a look at the basics of this investment and outline what employees need to know.
What Are Employee Stock Options?
Employee stock options (ESOs) represent a contract between a company and its employees that gives employees the option to purchase shares of the company’s stock at a specific price (the “strike price”) within a certain period of time. Employee stock options allow companies to align their interests with those of employees. If the company thrives, employees stand to benefit with appreciation in their stock’s value. This benefit may be magnified by the fact that some companies grant options at a price that is a discount to the stock’s fair market value.
Employees who are granted stock options hope to profit by exercising the options at a higher price than the price at which the options were granted, and then selling the shares to realize the gain after a specified period of time passes. The amount of time employees are required to wait to sell the shares and receive full value is commonly referred to as the “vesting” schedule.
Types of ESOs
There are two main types of options: nonqualified options and incentive options. The key way in which they differ is the taxation.
- Incentive Stock Options (ISOs)– also known as “qualified” stock options because they receive special tax treatment. When the option is granted and exercised, no tax is due and the tax liability is deferred until the stock is sold. At the time of sale, the entire gain is taxed at long-term capital gains rates as long as the stock is sold at least one year after it is exercised and two years after the option is granted.
- Nonqualified Employee Stock Options (NQSOs)– NQSOs do not qualify for the same preferential tax treatment as ISOs. Generally, employees owe no tax when these options are granted, but are required to pay ordinary income tax on the difference between the grant price and the stock’s fair market value when purchased by the employee. A key benefit is that they may be granted at a discount to the current fair market value.
- In addition to the stock options described above, some public companies offer Section 423 Employee Stock Purchase Plans (ESPPs). These programs permit employees to purchase company stock at a discounted price and receive preferential tax treatment on the gains earned when the stock is later sold.
Exercising ESOs
When deciding to exercise, it is important to review your individual investing strategy and overall financial plan. A long-term strategy can be implemented to allow for the company stock to appreciate and enable employees to maximize gain. However, there are also benefits associated with exercising options early:
- If your portfolio becomes heavily weighted with company stock and you want to spread out the risk to keep your overall plan balanced and diversified, selling shares may be advantageous.
- If waiting to exercise could push you into a higher tax bracket in the future, it may be wise to sell early. Remember that nonqualified ESOs are subject to tax when they are exercised. Avoiding exercising them all at once might reduce current tax liability.
- If you have lost faith in your employer’s prospects for future growth potential, reducing the exposure of your portfolio to your employer’s stock may be wise.
ESOs and Your Portfolio
ESOs can be more complicated to understand than individual stocks, but it is important that employees take the time to do so before they buy. If you are confused about some of the complex employee benefits offered through your employer, we are here to help you understand the intricacies of your particular plan.