An Employee Stock Option is typically included in a job offer as part of the incentive package for high-level employees.
The basics are pretty simple:
You receive an offer that includes a base salary and typical incentives such as health care coverage and paid vacation days – but you are also offered an Employee Stock Option.
Simply put, the option states that after a given period of employment – typically one year – you reach a “cliff” when you are allowed to buy a certain number of the company’s shares.
Why is that a big deal?
First of all, we are talking about a privately held company; you can’t buy the shares on the New York Stock Exchange.
More importantly, however, we need to talk about the price of the shares.
The price you will pay is determined by the fair market value of the shares at the time the employment agreement was signed.
So, if the fair market value was $100 at the time you started employment, and when you hit the “cliff” it was worth $200, you earn $100 per share by exercising the option.
Sounds simple? It gets a bit more complicated from here.
Are There Paperwork Requirements?
Frankly, not every employer is great about providing the proper paperwork.
Although the Employee Stock Option plan may be mentioned in your offer letter, you need to get a copy of what is called the Stock Option Agreement and sign it.
Not only is it an Internal Revenue Service requirement, but it will also spell out crucial details of your agreement.
What Are the Differences Between an ISO and an NSO?
Because we are discussing Employee Stock Options in the context of a potential employment contract, we are probably talking about an Incentive Stock Option (ISO) which is only available to employees, rather than a Non-qualified Stock Option (NSO).
Why is an NSO not qualified? An ISO is qualified because it meets the rigorous qualification requirements of the Internal Revenue Service.
An NSO must meet different requirements and is available not only to employees but to members of the Board of Directors, and outside consultants and contracts.
There are also significant federal income tax consequences as well.
There are a variety of other differences between the two.
For example, in an ISO the fair market value of the stock at the time of the offer can be determined – in good faith – by the Board of Directors at the time of the offer; whereas the value of NSO stock must be determined by an (expensive) expert in adherence with Internal Revenue Code section 409A.
But, most importantly, an ISO receives better treatment by the Internal Revenue Service than an NSO.
Can My ISO Become an NSO?
First of all, only $100,000 in value of a company’s shares can be exercised per year. Any amount over that is treated as NSO.
Second, with some limited exceptions, ISO rights cannot be transferred.
Finally, if you do not hold the ISO for certain minimum holding periods the ISO will be converted to an NSO.
The stock must be held for two years from the time the option was granted (granted, not exercised; typically the date of the hire) and must be held for at least one year from the time it was exercised
What Are the Risks Involved in Employee Stock Agreements?
An Employee Stock Option is part of your potential compensation package. Therefore, by definition, exercising the option should result in an increase in your wealth.
But that only happens if the privately held company that offered you the Employee Stock Option goes up in value.
As explained above, if the fair market value of the company’s shares was $100 a share on the date you were hired was $100 and when you hit your “cliff” (let’s say one year later) the shares were worth $200, and your agreement allowed you to buy twenty-five shares, your net worth just went up $2,500.
And if you sell the shares your income was $2,500.
But what if the business, and thus its stock, doesn’t go up in value at all?
If you buy the stock at $100 and can only sell it at $100, you have gained nothing. Worse yet, if you buy it at $100 and it is valued at $75 when you are ready to sell, you lost money.
The point is, an Employee Stock Option is only valuable if the company is going up in value; if it fails – as many businesses do – the Employee Stock Option is worth nothing or is even a liability.
What If You Are Fired or Quit?
There is a second downside to employee stock options that we will mention briefly.
What if you quit or are fired before the typical one-year “cliff” that we explained earlier?
One of the employer’s benefits from an Employee Stock Option is that it encourages the employee to stay on board even if she is not happy with her situation.
In that sense it is akin to what we call a “golden handcuff” agreement, defined as a sort of incentive that discourages an employee from leaving a company.
Can I Exercise My Option After I Leave My Job?
Typically the answer is yes.
But you may only have a short time frame; often ninety days. This should be spelled out in your stock option agreement.
How Are Employee Stock Options Taxed?
As they say: “Save the worst for last!”
Seriously, taxation issues are the most complicated part of Employee Stock Options, but we can work you through this as simply as possible.
The complications arise from the fact that ISOs and NSOs are treated differently and that there are two “events” that may trigger federal income tax consequences: exercising the option to buy the stock and selling the stock.
What Are the Tax Implications of an ISO or NSO Purchase and Sale?
Unfortunately, this section is going to get a little complicated.
The answer depends, first of all, on whether you have an ISO or an NSO but it also depends on changes in the value of the stock and the timing of your sale of the stock – if and when you do sell.
Tax implications can involve the tax on ordinary income, short term capital gains, long term capital gains and even the Alternative Minimum Tax (AMT).
If, to continue with the above example, the fair market value of the stock was $100 when you executed the Stock Option Agreement and when you bought it for $100 post-cliff it was worth $200 your theoretical gain was $100 per share.
If you have an NSO or your ISO has defaulted to an NSO, the difference will be taxed as ordinary income at your marginal tax rate.
That seems fair, since your wealth increased by $100 per share and it was essentially part of your salary.
Very important: if your agreement is an ISO there will be no taxable income recognized by the Internal Revenue Service when you exercise the option.
Now what happens if you sell the stock?
Let’s say the stock is worth $300 when you sell it. You already paid tax at ordinary income tax rates on NSO stock on the gain from $100 to $200, but the good news is that the gain from $200 to $300 is taxed as capital gains, and capital gains are taxed at significantly lower rates than ordinary income.
How Does the AMT Factor Into Your Tax Burden?
The Alternative Minimum Tax (AMT) can seem unfair: you have carefully planned to legally minimize your federal income taxes but your accountant re-calculates your taxes factoring in the AMT and you owe more taxes than you thought.
One of the many things the AMT adds into your taxable income is the difference between the value of the ISO stock at the time you signed the agreement and the value at the time you exercised the option.
This issue only matters with an ISO, not an NSO.
An employee stock option can be a very valuable part of your compensation package, but as you have seen there can be pitfalls as well.
Learn about stock option litigation or consider an employment lawyer to review your stock option offer before you make a decision to accept or reject an employment offer.