Congrats - you have been working at, or an advisor to, the same company for a long time, and you have amassed a pile of stock options that have been granted to you over the years. You are vested in them so now you have the right to exercise them. But should you? What is it going to cost and what are the tax implications? Many option holders do not know the answers to these questions, so they sit on their options and wait, sometimes not making the smartest financial decisions.
The first thing you need to understand about “exercising stock options” is that it is just that, a right or option to buy a share of stock at a certain predetermined price. For example, you may have 100 options that were granted at $1 apiece. You will give the Company the exercise price ($100) for the option and that will essentially be the payment for the share of stock. Sometimes companies will allow you to return shares as payment for the exercise, thus creating a “cashless exercise” scenario. Either way, you are paying for the share of stock at a price that was predetermined when the option award was made. As the share price of the Company stock goes up, you have the right to exercise an appreciated piece of stock and you need to know what to do with it. Remember that you never want to exercise your shares when the Fair Market Value (FMV) is below the exercise price; these shares are in theory “under water”, or of no monetary value to you.
The other very important fact that you need to understand is what type of option you have been granted. There are two types –a non-qualified stock option or a qualified option, also known as ISO (incentive stock option) and limited to employees only. Depending on what type you are holding, the tax treatment will be different. You need to understand this difference in order to maximize your after-tax award. Qualified options have certain tax attributes that could allow you to delay paying tax now at exercise, and also potentially pay the tax at lower capital gains rates.
You must first decide whether you are going to exercise the option and sell the shares immediately or whether you are going to hold on to the shares you just exercised. If you exercise and sell them immediately (remember if you are a private company there needs to be a market for your shares) then you will pay 1) the exercise price and 2) pay taxes at ordinary tax rates on the difference between your exercise price and the FMV at the time of exercise. This is true for both qualified and non-qualified shares. If you exercise and sell the shares immediately, all the income is deemed compensation (ordinary income) for both types of awards. So for example, if you have 10 options at an exercise price of a $1 and the FMV is now $5, if you exercise them you will pay $10 to the company to exercise them and pay taxes (at ordinary rates) on $4 of difference or $40. That could cost you approximately $12 of taxes. So the take home amount after selling your shares for $50, less the cost of $10 for the exercise, less $12 of taxes, is a net figure of $28.
An incentive stock option has certain rules it has to follow in order to be a qualified stock option. The benefit with these types of options is, if you exercise and decide to hold onto the shares for a specific time period, the appreciation in the stock from your exercise price to the FMV at exercise could be taxed at lower capital gain rates and be deferred until you sell. What you as the employee need to know is - 1) did it qualify as an incentive option when it was granted (ask the Company) and 2) have I held it long enough for it to be eligible for the qualified treatment. In order to meet the holding period rule, you must have held the option at least 1 (one) year from exercise or 2 (two) years from the grant date, whichever is less. Depending on your tax situation and depending on how many shares you exercise and hold, you could be taxed under the Alternative Minimum Tax (AMT) regime early upon exercise. Accounting firms like KN+S advising employees with ISOs need to do a great deal of planning around finding the perfect balance keeping their clients just out of AMT (and thus not paying tax on exercise of the qualified shares) on their exercise of qualified stock options (so not tax today if they hold shares) and the exercising of nonqualified stock options. This requires a lot of planning and creating multiple tax scenarios to maximize the after tax take home amounts and hit crossover of shares of each type.
If you happen to be a director or stockholder that receives options, generally they will have to be non-qualified stock options, since ISO’s can only be granted to employees. For the options to qualify for ISO treatment they would have to be furnished to you for service rendered as an employee of the company, and not for your service as a director.
It seems counter intuitive, but KN+S often tells its clients that one of the games you want to play is to exercise your options when the FMV is still low. If you can afford to sit on the shares and then hold them, the appreciation after the exercise will all be long term capital gain rates. For instance, if you have options with an exercise price of $1, and the FMV is $5, then exercise them. Depending on whether they are non- qualified or qualified options, you may or may not pay taxes on the $4 spread. But if you think the $5 is low, then now you own shares that cost you $5, and the appreciation from that point forward will be all long term capital gain rates. If you own shares in a private company, you should find out from the company what the FMV is at least once a year to make these financial decisions or moves.
The other thing to keep in mind is that all the options have an expiration date. Many option plans at companies have a ten year life, and you don’t want to be forced into acting quickly and lose the benefit of a well thought out execution strategy. Lastly, make sure you don’t have too much of your net worth tied up in one company stock. I am a big believer in diversifying your risk and having a plan to spread your asset holdings around in different types of stocks. Knowing the rules around options, monitoring your tax situation and having a well thought out plan can potentially reward you someday.
For more on cap table dynamics and option economics read Angel Investing by the Numbers: Valuation, Capitalization and Startup Economics and Pure Upside: Understanding Stock Options and Restricted Stock for Angels.
Jeffrey D. Solomon is the Managing Partner of Katz, Nannis + Solomon, PC. The firm is now ranked one of the Top 25 CPA firms in Massachusetts and its emerging business group has grown to be a true leader in Massachusetts. Jeff can be reached at firstname.lastname@example.org.