By Sean Lovison, CFP, CPA
Key takeaways:
● Stock options: Stock options in executive compensation are promising but volatile and can sometimes expire worthless.
● Option types: The two main types are non-qualified stock options (NQSOs) and incentive stock options (ISOs). This article focuses on the more common NQSOs.
● Essential terms: Understand grant date, strike price, expiration date, exercise date, vesting schedule, and fair market value (FMV).
● NQSO taxation: Tax applies at exercise; taxable income is the difference between FMV and strike price, taxed at ordinary income rates. There could also be capital gains taxes if the shares are held after exercise.
● Tax strategies: Optimize by timing the exercise for lower tax brackets, consider market conditions, cash needs, and risk mitigation when deciding to hold or sell stock.
Introduction
Stock options are undoubtedly one of the most intriguing and impactful components of an executive compensation package but can also be the most complex. These versatile financial instruments possess the potential to significantly accelerate the accumulation of wealth and secure your financial future. However, it is important to understand that stock options come with inherent variability, as their value can experience dramatic fluctuations, ranging from a substantial fortune to potentially nothing at all.
There are two primary types of stock options: the simpler and more common non-qualified stock options (NQSOs) and the more complex incentive stock options (ISOs). While both forms can yield significant returns for their holders, ISOs come with additional tax benefits. However, this article will specifically concentrate on NQSOs and explore the tax strategies that can be employed to maximize their wealth-building potential.
Navigating the complex realm of stock options can be a daunting task, particularly if you are new to this form of compensation and lack the time to dedicate hours to financial research. Options come with their own distinct terminology and intricacies that require careful consideration and understanding.
Terms and examples
When a company grants an employee stock options, it is essentially compensating the employee with the right to purchase shares of the company’s stock at a predetermined price. Here are the list of the terms important for understanding about options:
● Grant date: The date on which the stock options are awarded or granted to the employee. This is the starting point for determining vesting schedules and other conditions.
● Strike price: Sometimes also referred to as the exercise price, it is the predetermined price at which the employee can purchase the company’s stock when exercising the option. The strike price is typically set below the current market price to provide an opportunity for potential gain.
● Expiration date: The last date on which the employee can exercise the stock options. After this date, the options become invalid, cannot be exercised, and are now worthless.
● Exercise date: The date on which the employee chooses to exercise the stock options and purchase the underlying shares at the strike price.
● Vesting schedule: The timeline or conditions that determine when the stock options become eligible for exercise. Vesting schedules can be based on factors like tenure with the company, achievement of performance milestones, or the passage of a specific period of time. Since most equity compensation tools, including options, are subject to vesting, a separate vesting article has been created and found here to avoid being overly repetitive. Please refer to that section if you want more information on vesting including an example of how multiple years of vesting can build on each other.
● Fair market value: The current market price of the company’s stock at a given point in time. The FMV is used to determine the spread or the difference between the strike price and the market price, which influences the taxable income when exercising the options.
Examples
The best way to explain options is to work through a couple examples. Let’s assume you work for Manatee Corp, a manufacturer of manatee medicine and care products, and as part of your compensation package, you are granted stock options on May 5, 2020 (this is now the grant date). The stock option specifies that you have the right to purchase 1,000 shares of Manatee Corp stock at a strike price of $50 per share. The option has an expiration date of one year from the grant date.
Scenario 1: Stock price increases
On May 4, 2021, a day before the option will expire, the stock price of Manatee Corp rose to $70 per share. Since the stock price is now higher than the strike price of $50, you decide to exercise your option. You purchase 100 shares of Manatee Corp stock at $50 each, using your option. May 4, 2021 is now the exercise date. You now own 100 shares of Manatee Corp stock at a cost of $5,000 ($50 strike price x 100 shares). If you decided to immediately sell the stock, your gain would be $2,000.
Scenario 2: Stock price decreases
Instead, now on May 4, 2021, the stock price of Manatee Corp declines to $40 per share. In such a situation, it would be prudent not to exercise the option since the stock price is below the strike price. By opting not to exercise, the option would expire without any value, resulting in no additional costs. However, it’s important to note that the options you were granted would become worthless, indicating that the compensation initially granted holds no value.
Here are both scenarios for comparison:
Market value of stock at exercise
$70
$40
Strike price
$50
$50
Gain per share
$20
$0
Number of shares
$100
$100
Total Gain
$2,000
$0
It is worth emphasizing that in scenario 1, there is no obligation to sell the stock immediately after exercising the option; we only demonstrated the sale for illustrative purposes to showcase the potential gain. Should you choose to retain the stock post-exercise, you will be exposed to future fluctuations in the stock price, which can affect your gain positively or negatively.
Related: Using asset location to minimize income tax while reaching your investment goals
Exercising the options
Once the options have vested, you will possess full ownership rights of the option contracts and can exercise them at your discretion within the option period. In our first stock option contract example we used an option period of one year for simplicity but the typical time period for an option granted as part of compensation is 10 years (again, read your agreement for precise information).
Upon choosing to exercise the options, it is necessary to acquire the company’s stock by purchasing it at the predetermined strike price. When you exercise the options, you may need to have funds available for the purchase. However, some employers offer a cashless exercise. You essentially borrow the money needed to exercise the options from the company’s broker, and the broker immediately sells enough of the acquired shares to cover the cost of the exercise and any associated taxes. This method doesn’t require you to use your own cash but may result in a smaller number of shares acquired.
Now, you are officially the owner of the shares, similar to any other stock, and have the freedom to make decisions based on your individual financial objectives and tax planning considerations, which may be influenced by the specific type of option involved.
Up until this point we have described how options work in general but now let’s discuss how NQSOs in particular work.
Taxes on NQSOs
At their core, NQSOs are very similar to the basic option contract we outlined when explaining options. Their value comes from the difference between the market price of the option and strike price but it is important to understand the tax impacts their granting, vesting, and lastly exercise:
Time of grant: At the time the NQSOs are granted the executive, NQSOs do not trigger any tax implications. The grant itself does not result in taxable income for the employee.
Time of vesting: When NQSOs vest, meaning the employee becomes eligible to exercise the options, no tax consequences occur. The vesting of NQSOs does not trigger any taxable events for the employee. This is favorable, it allows more control for the employee to implement tax planning strategies later when the options are exercised and income is recognized (see next).
Time of exercise: Taxation comes into play when NQSOs are exercised. The difference between the fair market value of the stock on the exercise date and the exercise price (also known as the “spread”) is considered taxable compensation income. This spread is subject to ordinary income tax rates and is typically added to the employee’s W-2 or 1099-MISC form.
Note: If your company allows an 83(b) election, this may change the tax implications and create a tax liability when the 83(b) is filed. This filing could create additional risk for the employee as they now have paid tax on compensation which would later be worthless, but does also create the opportunity to convert some of the compensation from ordinary income to capital gains (and be taxed at the lower rates).
From our previous example, if the FMV of the stock on the exercise date is $70 per share, and the exercise price is $50 per share, the spread would be $20 per share. If the employee exercises 1,000 shares, the taxable compensation income would be $20,000. This portion of the gain would be taxed as ordinary income at ordinary income tax rates.
Tax strategies for NQSOs
The usual 10-year expiration date (not the one year used in the simple example) comes into play here, allowing for multi-year tax planning. It puts the executive in control of when they exercise the option and absorb the increase in taxable ordinary income.
One tax strategy is to simply wait and defer all of the taxes until just before the options expire. This is more of a passive strategy and is probably not the smartest since it could find you getting bumped into a higher tax bracket due to the exercise of all the options in the same year.
A better tax strategy that can be employed is to “full up” a lower tax bracket before crossing over into the next higher bracket by exercising options. Years when company performance is lower and other variable compensation components such as cash bonuses are lower are excellent years to consider this strategy.
Let’s look at the current ordinary income tax rates for a taxpayer filing as Married Filing Jointly in 2023:
10% for incomes up to $22,000.12% for incomes from $22,001 to $89,450.22% for incomes from $89,451 to $190,750.24% for incomes from $190,751 to $364,200.32% for incomes from $364,201 to $462,500.35% for incomes from $462,501 to $693,750.37% for incomes over $693,750.
If the taxpayer is currently in the 24% bracket with a predicted household income of $250,000, they may want to exercise NQSOs to generate additional ordinary income of $114,000. This would bring their total income to $364,000, just below the start of the 32% tax bracket. It is especially beneficial to fill up these lower tax brackets if they are forecasting higher salaries or additional bonuses in future years.
Other than taxes, there may be other reasons to exercise the options sooner than later once vested, those include:
Market volatility: If you expect the stock price to decline significantly in the near future, executing a disqualifying disposition allows you to lock in the gain at the current market value before potential depreciation occurs.Cash flow needs: If you require immediate cash and do not have the financial means to hold the stock for the required holding period, a disqualifying disposition enables you to access the proceeds from the stock sale promptly.Risk mitigation: Holding company stock carries risks, such as concentration risk or changes in the company’s financial stability. Opting for a disqualifying disposition allows you to diversify your investments and reduce exposure to a single stock.
After exercising the NQSOs, the employee assumes ownership of the acquired stock. They have the option to retain the stock or sell it. If the stock is sold in the future, any profits or losses will be subject to either long-term or short-term capital gains tax, depending on the holding period and the difference between the sale price and the fair market value on the exercise date. If you decide that you want to hold onto the shares after exercising the options and the stock does increase in value, you will want to hold the stock for at least a year and one day to realize the lower long-term capital gains tax rate. If sold for less than that, the gains will be considered short term capital gains and taxed at the same rates as ordinary income.
Remember, the tax dog is not the guide dog for your life. There is a lot more to your financial independence than lowering your current-year taxes. Risk mitigation, including avoiding a possibly highly-concentrated position in your company stock, needs to be considered.
Conclusion
Please keep in mind that tax regulations and rates can differ based on various factors, including the employee’s tax bracket and the duration for which the stock is held. Seeking guidance from a tax or financial professional advisor is essential to ensure adherence to tax laws and gain a comprehensive understanding of the tax consequences associated with NQSOs, tailored to one’s specific circumstances.
It can not be repeated enough, it is of utmost importance to carefully review the plan documents or, alternatively, share them with your adviser for a thorough examination, while concurrently establishing a robust, long-term tax strategy.
Congratulations on your success and being granted these exciting compensation vehicles, you earned them through all of your hard work. Now make sure they are used to their fullest to provide you a path to financial independence and purpose.
About the author
Sean Lovison, CFP, CPA is a Principal with Purpose Built Financial Services, LLC.
Editor’s Note: The content was reviewed for tax accuracy by a TurboTax CPA expert for the 2022 tax year.
