Employee stock options, which allow employees to buy shares of the company they work for at a discounted rate, are an excellent way for employees to reap some reward from their employer’s success. As such, they have remained popular as a part of many employee compensation packages for decades.
It’s critical that any employee who accepts stock options as part of their compensation also understand the different factors associated with exercising those options (or, essentially, purchasing them at the previously agreed-upon price, regardless of their current value).
There are plenty of considerations to keep in mind when exercising your options. However, getting the timing right is at the top of the list of priorities.
As the end of the year bears down on us, you may wonder if you should exercise your stock options before 2023. Taxes are often a major concern for employees with stock options, after all, and if you expect to make more money next year than you did in 2022, it may be wise to exercise your options before the ball drops.
In this post, we’ll review how employee stock options work and dive deeper into what you need to know before exercising your options at the end of the year.
An employee stock option is exactly what it sounds like: the option for an employee to purchase stock in their company. The biggest advantage, and the thing that makes stock options so attractive, is that it gives the employee the right (but not the obligation) to buy or sell the stock within an agreed-upon timeframe — at an agreed-upon price. That means that if you accept stock options, you can buy the stock at a specific price regardless of the stock’s actual share price within a set period.
There are two basic categories of employee stock options (ESOs):
The employer determines the type of option offered to an employee, and the main difference between these two categories is how the IRS treats them for tax purposes. The good news is that you are unlikely to incur any taxes when you receive the option in both cases.
To learn more about how employee stock options are taxed and reported and how to get the most out of yours, look at our previous article here.
Exercising your stock options can be fairly straightforward — or at least as clear as a sophisticated financial transaction can be! That said, depending on how you approach the transaction, it can also be pretty complex. And, as in any such transaction, it’s vital to ensure you approach it carefully and thoughtfully, with all the relevant information at your disposal.
The most common way to exercise stock options is to purchase the underlying shares at the exercise price and then sell them on the open market for the current market price (ideally, for a profit). When combining both of these steps into one, purchasing and selling your shares simultaneously without using any of your own cash to cover the transaction, the process is known as a cashless exercise.
Another type of exercise transaction you could initiate is an exercise-and-hold, in which you exchange cash for stock and then hold the stock to sell at a future time when it appreciates. This may be useful, especially if you are nearing the end of your vesting period and the company’s stock is expected to increase. Alternatively, you could initiate an exercise-and-sell-to-cover transaction, in which you sell just enough of your new shares to cover the cost of the purchase, as well as any related taxes and fees. You can then hold the remainder of your shares, again in anticipation of their value appreciating.
Much of getting the most out of your employee stock options comes down to timing. On one hand, your vesting schedule won’t last forever, so you’ll need to act before your options expire. On the other hand, it may be advantageous to spread out the sale of your stocks over time, to cushion their value against market fluctuations.
So, what factors should you consider when deciding whether to exercise your options before 2022 becomes 2023?
First, it’s vital to evaluate current market conditions, the future outlook of the company, and your own financial situation. There may also be tax implications specific to your case that will make exercising now more beneficial than waiting until the new year.
For example, if your stock options are nearing expiration, exercising sooner rather than later may help ensure that you can benefit from potential future gains in the market price of your shares. Additionally, depending on your circumstances, exercising your options before the end of the year can help you manage your tax liability.
Remember, exercising your options is a taxable event. That means you must consider how doing so will impact your income tax bill. More importantly, it would help if you also made the decision in context with your broader financial goals and planning.
Furthermore, initiating an exercise-and-hold or an exercise-and-sell-to-cover and selling a portion of your shares while retaining another portion can spread the income from your exercise over multiple years, potentially reducing your tax burden in any given year.
If you exercise non-qualified stock options, the income you gain from the transaction is subject to regular income taxes on the amount of the difference between the purchase price and the current market value of the stock. Meanwhile, while selling qualified or incentive stock options doesn’t incur regular income tax at exercise, the “bargain element” (the aforementioned difference between price and value) may create an alternative minimum tax adjustment, which can land you a hefty tax bill. Of course, depending on your circumstances and expectations for the new year, it may be helpful for you to take some of that tax burden this year rather than next.
You can also sell your stocks to fund another purchase or diversify your investments.
Regardless, you should always try to exercise your stock options when the stocks have value or when selling them on the open market will yield you a profit. If you expect the value of your shares to decrease long-term, consider exercising while they are at their peak. Of course, it all depends on the particulars of your circumstances.
Finally, you should also consider whether your company is public or private. Public or soon-to-be public companies may have liquidity (although this is not the case one hundred percent of the time, as companies sometimes have blackout or lockup periods when shareholders are restricted from selling stocks). On the other hand, employees of private companies often don’t have an excellent way to convert stock options into cash until a liquidity event, such as an IPO, recapitalization, or the sale of the company.
There are plenty of factors to weigh when deciding on the timing of exercising your stock options. Every situation is different, and exercising your options is never entirely without some degree of risk. However, broadly speaking, you should consider the current market conditions, the company’s outlook, your financial priorities, and the tax implications of the transaction.
You may want to consider exercising your employee stock options before the clock strikes midnight on December 31st if:
Of course, for the best advice regarding your own unique circumstances, nothing can replace the counsel of an experienced tax professional.
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Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.
He is a diligent financial professional, able to manage the details and turn them into relevant business leading information. He has a strong financial background in construction, technology, consulting services and risk management. He also knows what it takes to create organizations having built teams, grown companies and designed processes for financial analysis and reporting.
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Prior to joining the firm in 2015, Jeff was in the private sector where he held senior financial and management positions including Controller and Chief Financial Officer. He has experience across industries, including construction, technology and professional services which gives him a deep understanding of business.
Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.
Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004. After a career of public accounting and general management, Jody knows the value of good financials. Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.
He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles. His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.
He has a particular expertise in early-stage growth companies. His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.
Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller. He has experience across industries, which gives him a deep understanding of business.
Jody graduated with a BBA in Accounting from Baruch College, he is a CPA and member of the American Institute of Certified Public Accountants and New York State Society of Certified Public Accountants.
In addition to delivering above and beyond accounting results, Jody is a member of the NYSCPA’s Emerging Tech Entrepreneurial Committee (ETEC), Private Equity and Venture Capital Committee and Family Office Committee.
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