How to Manage Your Company Stock Options

Key Takeawaysbusinessreview

  • A stock option is a form of compensation that gives an employee the potential to purchase company stock at a discount to the market price.
  • Before exercising, make sure to understand the type of option you have, potential tax impact, and vesting schedule to determine the best time to potentially exercise.

Over the years, I’ve worked with many people who were employed by public companies. One of the best parts of working for a publicly traded company can be participating in company stock. This can come in many forms, such as employee stock purchase plans, restricted stock, stock appreciation rights, etc. But perhaps the most common form of stock-based compensation that public companies use are stock options.

Many clients have a great deal of difficulty understanding how stock options work and how best to manage them. During my time at PricewaterhouseCoopers, I worked with a number of Executive’s to help them through this process, and have now done the same with a few clients at Independence Advisors.

Given that each situation is specific to the individual, I won’t be able to answer all questions in this post. But what I’d like to do is list 5 common questions to help you better understand the options you may have and how to handle them. We recently helped a client who is nearing retirement better understand her stock options and come up with a long-term plan of managing them. If you have questions on your own stock-based compensation, please don’t hesitate to contact me, I’m happy to help. Now to the questions.

1) What is a stock option?A stock option gives the employee the right, but not the obligation, to purchase a set amount of company stock at a named price. For example, I worked with a client who received a stock option grant in March 2014 from her employer, Comcast, to purchase 2,500 shares of Comcast stock at $50 per share. As of close of business 7/6/15, Comcast is trading at $62.11, which means if our client is eligible to exercise the option to purchase the stock at $50 per share, she stands to make $30,275.

2,500 shares X $62.11 market price = $155,275
2,500 shares X $50.00 exercise price = $125,000
Profit = $30,275

2) What type of stock option do you have?Stock options come in 2 forms: Nonqualified stock options (NQSO) or Incentive stock options (ISO). NQSO’s tend to be more common than ISO’s, but the real differences relate to tax treatment.

3) What is the tax impact of exercising my stock options?NQSO’s require tax to be paid at the time of exercise. The amount subject to tax is the difference between the market price of the stock and the exercise price of the option, which is the $30,275 in the example above. This difference is commonly known as the bargain element, and upon exercise this amount is taxed at your ordinary income tax rates. Upon exercise, you may decide that you want to hold the shares rather than cash out immediately. Although the bargain element will still be taxed regardless, any subsequent gains after exercise will receive capital gain treatment. This could result in a more favorable tax rate if you hold the stock for more than 12 months after exercise.

ISO’s qualify for more favorable tax treatment since there is generally no tax owed upon exercise. You report the taxable income only when you sell the stock. That means the entire profit could be taxed at capital gain rates, which can be more favorable if you hold the stock long enough after exercise! The catch with ISO’s is the bargain element will be included in your Alternative Minimum Tax calculation, therefore discuss with your advisor or CPA before exercising.

4) When do your stock options vest?If you’re familiar with the term “golden handcuffs”, most times it is used to describe a vesting schedule of some sort. When stock options are granted to an employee, they must continue to work for the company before being able to exercise any of the options. For example, the Comcast employee above has a 5 year vesting schedule for the 2,500 options she was granted, so 20% (or 500) of the options will vest each year. When options vest, she’ll then have the ability to exercise them if she chooses.

5) When should I exercise my vested options?This question typically requires a bit more of analysis. Some of the considerations that go into this decision include:

  • Your feelings about the underlying stock and its long-term return potential.
  • What impact exercising options will have on your current taxes.
  • When options may expire. If you don’t exercise options before they expire (typically 10 years after being granted) you will lose them and any related profits, so it’s important to develop a schedule of how to best exercise options over time.
  • How long you may be employed at the company since you might have to exercise at separation, or a few months after separation in order to not lose the option value.
  • Risks associated with a concentrated stock position if you plan to not cash out immediately upon exercise.

About Patrick Runyen

As a Wealth Manager at Independence Advisors, Patrick Runyen, CPA/PFS, CFP® works closely with clients to implement wealth management solutions. He leverages his technical financial planning and consulting experience to assist clients with investment counseling, retirement planning, estate planning, wealth enhancement, asset protection, tax planning, and other personally significant financial decisions. CLICK HERE TO ASK PAT.

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