Employee Stock Options, Explained

Employee Stock Options, Explained

Maybe you’ve paid your dues for years and are finally being tapped for upper management. Or perhaps you’re being recruited by a tech startup who wants you to get in early on a big venture.

In either case, a company may try to woo you with a compensation package that includes stock options, which are used to tie your total pay to the company’s performance so that if the company does well, you do well. While stock options won’t pad your paycheck right away, they can help grow your wealth in the long run.

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But if you’ve never had to deal with stock options before, it’s easy to get overwhelmed by all of the jargon. So we’ve collected eight of the most common terms you might come across and decoded them, so you’ll know what, exactly, you’re being offered.

1. Stock Options

Let’s start, naturally, with stock options themselves. If you’re receiving stock options, it means your employer is offering you the right to purchase shares in the company at a predetermined price. Often this price is at a discount to what the shares were worth on the market at the time they were granted.

Stock options come in two main flavors: non-qualified stock options and incentive stock options, both of which we’ll get into later. The main difference between these two is how they are treated when it comes time to pay taxes.

2. Vesting

Vesting is the amount of time you have to be employed before you can take advantage of your stock options. By making you wait, the employer is enticing you to stick with the company for some specified amount of time. Usually, a company will have a vesting schedule for your options.

For instance, they may offer you a package that vests over four years, with a one-year cliff. This means you aren’t entitled to any options until you’ve worked for the company for at least one year. If you make it to your one-year anniversary, you’ll then be 25% vested in your total options package. After that, the vesting could be prorated on a monthly basis, so that each month you’re vested an additional 1/48th (because there are 48 months in four years). By year two, you would be 50% vested, by year three, 75% and by year four, 100% vested.

This means that if you left after working for two years, you would only have the right to purchase half of your total options package. However, how companies choose to set up their schedule and rules can vary, so it’s important to be sure you understand what happens to your options should you leave before you’re fully vested.

3. Exercise

If you exercise your stock options, that means you’re actually purchasing the shares you’re entitled to at the price set in your contract (sometimes called the “exercise price” or “strike price”). You can only exercise as many options as you are vested for. Once you are vested, you usually have a specified amount of time to purchase the shares before your options expire.

Some people choose to exercise their options as soon as they are eligible. Others wait to exercise until the share price is at a level at which they would be willing to sell (e.g., because the share price has risen much higher than the strike price). There is no right or wrong decision for when to exercise; it’s dependent on your own circumstances and tax situation, as exercising and selling may trigger a tax liability.

4. Fair Market Value

This is the amount of money your stock would be worth if it were sold on the open market on the day that you exercised your stock options. The difference between your strike price and the fair market value (also known as the bargain element) clues you in on how much you’d stand to gain if you sold your options, as well as what the potential tax impact of selling might be, depending on whether your options are categorized as non-qualified or incentive stock options.

5. Non-Qualified Stock Option

Non-qualified stock options, sometimes abbreviated as NSOs or NQOs, are more commonly offered by companies than incentive stock options. They are called “non-qualified” because they do not qualify for the same tax advantages that incentive stock options get.

As such, when you exercise a non-qualified stock option, you will pay taxes two times. You will first pay ordinary income tax on the difference between the fair market value and the exercise price of the stock, as this difference is considered compensation by the IRS (even if you haven't actually made any money by selling the shares). Then when you ultimately sell the stock, you will pay capital gains taxes (assuming you sell at a gain) that will be dependent upon how long you’ve held the stock. If you’ve held the stock for a year or less, you’ll pay taxes at the short-term capital gains rate. If you’ve held it for more than a year, you’ll pay taxes at the long-term capital gains rate. If you sell at a loss, you can record it as a capital loss for tax purposes.

6. Incentive Stock Option

Incentive stock options, also known as ISOs, have a more favorable tax treatment. When you exercise ISOs, you do not pay ordinary income taxes on the difference between the fair market value and the exercise price, as you do with NSOs. Instead, you only pay capital gains taxes (or record a capital loss) when you ultimately sell your stock.

There is a limit, however, to the total value of ISOs that can become exercisable in a given year and still retain this tax benefit, known as the $100,000 limit. That $100,000 refers to the fair market value of your options at the time they were granted, but the tax rule itself takes your vesting schedule into consideration.

So, for example, if your stock has a total fair market value of $120,000 but vests over four years, that means each year the exercisable amount is only $30,000 — as such you’d still fall within the limits of the rule. If for some reason your exercisable amount exceeds $100,000 in a given year, anything above the limit would be treated as NSOs tax-wise.

ISOs also have holding periods you have to meet before you can sell them. You must hold them for at least 2 years from the date of the option grant and at least one year after exercising them; otherwise you may lose out on their tax benefits.

7. Restricted Stock Award

A restricted stock award is a predetermined amount of stock that belongs to an employee once certain restrictions have been met. These restrictions are usually related to a vesting period, employee or company performance or some combination thereof.

Restricted stock is different from stock options in that there is usually no purchasing involved. Regular employee stock options grant you the right to purchase stock at an exercise price, but restricted stock is awarded to you outright after the restrictions are lifted. (Some companies may require you to purchase a restricted-stock grant from them, but this is less common.) Once your award vests, you can choose to receive it either in shares or in the shares’ cash equivalent.

Because you typically haven’t paid money upfront to buy your shares, your restricted stock award will almost always represent a profit to you. You will, however, have to pay taxes. You will have to pay ordinary income taxes on the fair market value of the stock in the year that it vests, then you’ll have to pay capital gains tax on anything above that fair market value when you eventually sell.

8. Employee Stock Purchase Plan

An employee stock purchase plan (ESPP) is a form of equity compensation that some companies offer their employees, with the intention of making it easier for workers to purchase company stock (sometimes at a discounted price). ESPPs allow employees to use after-tax payroll deductions to buy the shares; the employer then holds the contributions in an account until a specified purchase date that typically comes around every six months.

RELATED: No Raise? 6 Ways to Squeeze More Money From Your Job

This publication is not intended as legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.

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