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how employee stock options work

How Employee Stock Options Work, ESO
Getting the Most Out of Employee Stock Options
Your Timetable, Deadlines, and Money-Making Strategies

Getting the most out of
your Employee Stock Options
Are you fortunate enough to have Employee Stock Options at your company? Learn all about Employee Stock Options to get the most out of them. We answer all your questions about your timetable and deadlines, money-making strategies, how to save taxes, ESO requirements, when to exercise, and when to sell.
  1. What Are Employee Stock Options
  2. The Big Benefits of Employee Stock Options
  3. The Difference Between Employee Stock Options
    And Traded Stock Options
  4. Important Dates for Your Employee Stock Options
  5. The Difference Between Nonqualified Stock Options
    And Incentive Stock Options
  6. Federal Income Tax on Employee Stock Options
  7. Be Smart When You Exercise Your Employee Stock Options

how employee stock options workWhat Are Employee Stock Options

Employee Stock Options
are called golden handcuffs
Employee Stock Options are offered by companies to some employees as another form of compensation or part of the benefit plan. Employee Stock Options, called ESOs, are contracts that give the employee the right to buy some shares of company stock from the company at a specified price. They are sometimes called "golden handcuffs," because the purpose of Employee Stock Options is to motivate employees, to retain valuable employees, and to lower the company payroll expense.

Employee Stock Options are used most often by publicly traded companies and fast-growing companies that expect to go public. The company grants options to pay employees with an IOU rather than cash, anticipating that the stock market, not the company, will one day pay off. Employee Stock Options work best for small companies that expect to have an IPO someday, that is, a public offering of stock. They also are used by publicly owned companies who want to offer some degree of company ownership to employees.

how employee stock options workThe Big Benefits of Employee Stock Options

Employee Stock Options offer
potential for financial rewards
What are the benefits of an ESO? ESOs offer employees the potential for significant financial rewards. Employees who have been granted stock options hope that the share price will go up and that they will be able to "cash in" by exercising their options. That is, they buying the stock from the company at the low ESO price and then sell the stock in the stock market at a higher price. For example, workers in young companies like Microsoft and Google, granted ESOs when stock prices were low, became millionaires as the market price zoomed astronomically over the years. ESOs are still popular with companies in every industry. According to the National Center for Employee Ownership as many as 9 million employees participate in some 3,000 plans. In 1990, only 1 million U.S. employees had them.

The drawback of your ESO is that in a declining stock market, ESOs can become worthless. Then, too, if for any reason the company is unable to deliver the stock against the option contract upon exercise, the employee may have limited recourse.

how employee stock options workThe Difference Between Employee Stock Options
And Traded Stock Options

An Employee Stock Option is different from publicly traded stock options because it has a vesting requirement, it cannot be sold, it cannot be traded on an exchange, and you do not benefit if the stock price falls. If, over the years, the stock price does fall below the option grant price, a company may grant new lower-priced options, allowing employees to exchange underwater options for ones that are better.

how employee stock options workImportant Dates for Your Employee Stock Options

The Employee Stock Options
are your piece of the pie
With Employee Stock Options, there are four important dates on your timeline. They are the date the ESO is granted, the date the ESO vests, the date the ESO is exercised, and the date the ESO expires.

GRANTING DATE Let's suppose you are fortunate to be granted employee stock options that allow you to buy 1,000 shares of stock from the company for $5 per share. You do not pay anything when the ESOs are granted to you. Until the ESOs vest, they cannot be sold and they have no market value.

VESTING DATE The ESO contract specifies that the options vest after a certain time, say 5 years, and will then belong to you. If you leave the company, you can only exercise your vested options and you will lose any options that are not vested.

EXERCISE DATE When you decide to exercise your ESOs, you pay the company the price specified. In exchange, the company will give you new shares of stock or shares of treasury stock. If the price of company stock falls lower than the ESO grant price before you exercise the options, you still hold the options, and have lost no money. Naturally, you are optimistic that the stock price will increase, so you bide your time.

EXPIRATION DATE You have the right to exercise your Employee Stock Options any time after they vest and before they expire. After the expiration date, your stock options are worthless. Most stock options expire about ten years after they are granted.

how employee stock options workThe Difference Between Nonqualified Stock Options
And Incentive Stock Options

In the stock market
there are no guarantees
Employee Stock Options usually fall into two categories: Nonqualified Stock Options and Qualified Stock Options. Qualified Stock Options are also called Incentive Stock Options, ICOs. The majority of ESOs are Nonqualified Stock Options, because incentive options are generally offered only to upper management. Unlike ISOs, nonqualified stock options can be granted at a discount to the stock's market value. They also can be transferred to your children and to charity. But your gain on nonqualified stock options is taxed upon exercise. We consider nonqualified ESOs in this article.

On the other hand, the ISOs offered upper management qualify for favorable tax treatment as capital gains. The income tax is paid, not when the option is exercised, but later when the shares of stock are sold, provided the shares are held for a year after the options are exercised. ISOs cannot be granted at a discount to the stock price, and are not transferable, except by will.

how employee stock options workFederal Income Tax on Employee Stock Options

There are no tax consequences when Employee Stock Options are granted and none when the options vest. But when you exercise your ESOs and receive shares of company stock, you will owe federal income tax on your gain. Nonqualified stock options, those most often granted to employees, are taxed when you exercise them. The tax is computed as the difference between the current stock price and the grant price you pay the company. This gain is taxed as ordinary income. If your gain is large, you will be in a higher income tax bracket. This gain is considered a preference item subject to the dreaded alternative minimum tax. Your tax basis for the shares of stock you now own becomes the stock price on the day you exercise.

If you expect the stock price to rise, and want to hold the company shares long-term, consider this strategy to lower your income taxes. By exercising your options as soon as possible, you will have less taxable ordinary income. Most of the investment gain will be taxed when you sell, at favorable capital gains tax rates which are 15% as of 2010. You should consult a tax advisor for strategies to minimize your taxes.

Tax Case #1. Suppose you exercise your ESO for 1,000 company shares at $6 each and sell the shares of stock immediately in the stock market for $10 each. Your taxable gain is $4,000, computed as ($10 - $6) x 1000. This gain must be reported as ordinary income on your federal income tax return.

Tax Case #2. Suppose you exercise your ESO for 1,000 company shares at $6 each when the stock is selling for $10. But you hold the shares of stock. The stock price rises to $12 and you decide to sell your shares at a profit. You must report a taxable gain of $4,000 as ordinary income, computed as ($10 - $6) x 1000. Later, you must also report a capital gain of $2,000, computed as ($12 - $10) x 1000.

Tax Case #3. Suppose you exercise your ESO for 1,000 company shares at $6 each when the stock is selling for $10. You decide to hold the shares of the stock. But the stock price FALLS to $5, and you sadly decide to sell. The bad news is that you still must pay income tax on the $4,000 as your gain when you exercised your ESO. If it's any consolation, you also get a capital loss of $5,000 to deduct, computed as ($10 - $5) x 1,000.

how employee stock options workBe Smart When You Exercise Your Employee Stock Options

When you are ready to exercise your Employee Stock Options and claim your company stock, you must pay cash to your employer equal to the grant price. You may not have that much cash on hand. The most common tactic for employees is to borrow money from a stockbroker while simultaneously selling enough of these shares to cover your costs. Or, instead of cash, you can swap employer stock you already own. Whenever you exercise, also plan on selling enough shares of stock to raise cash to pay the income taxes due.

When should you exercise your Employee Stock Options? For some people, it is smart to hold options as long possible, until the expiration deadline. They take advantage of stock price increases and, therefore, maximize their gain and postpone paying taxes. But a more conservative way to deal with stock options is to view them as income from the job. When you decide to exercise your options, sell all the shares of stock immediately. Then, put the money into other investments. As suggested above, you can reduce your ordinary income tax by exercising your stock options early.

But there are no guarantees in the stock market. If your company is failing or is likely to fail, the time to exercise your ESOs is right now. Exercise your ESOs, sell your company stock, and look for better investments. Stockbrokers may also suggest hedging strategies, buying puts and selling calls on the company stock, to protect you from a decline in the company stock price. Income tax considerations also come into play.

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