Why do companies give stock options to employees?

A common way for companies to attract and retain employees, stock options are a form of equity compensation that allows employees the opportunity, if they choose, to purchase shares in the company at a predetermined price.

If you work for a small startup, then getting stock options can be an excellent incentive for helping the company grow. They may even become more valuable than your salary one day, as in the case of the so-called “Microsoft millionaires,” former employees who accepted stock options in the early days of Microsoft and subsequently became wealthy when the company took off.

There are two basic categories of employee stock options (ESOs):

  • Statutory (qualified) stock options are granted as part of an employee stock purchase plan or incentive stock option (ISO) plan.
  • Nonstatutory (nonqualified) stock options are granted without any kind of plan.

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.

Statutory (qualified) stock options

Qualified stock option plans offer tax advantages and must comply with specific IRS rules. Most statutory stock options do not produce any immediate taxable income because you must the stock to make money off of your option.

Therefore, most qualified stock option plans require you to purchase the stock and hold it for at least one year before selling, after which any gain on the sale is subject to favorable capital gain tax rates.

Nonstatutory (nonqualified) stock options

Nonqualified stock options have fewer restrictions than qualified stock option plans. For example, the granting of the option is only taxable when its fair market value can be easily determined (for example, if it is already being traded on an exchange).

However, this is not usually the case, so no tax typically results from this event.

If you purchase stock at a discount under a nonqualified stock option plan, the bargain element (the difference between the option price and market value) is taxable to you as wages at the time you exercise the option.

Another important point: the term “nonqualified stock option” is a technical term describing certain types of stock options granted to employees. The term refers to how the IRS taxes the gain, not to the legitimacy of the transaction.

Generally, stock options include a predetermined price-per-stock, or exercise price, which is guaranteed and unaffected by market fluctuations; there is an opportunity for the option holder to profit if the market value of the stock increases.

For example, if your company offers you stocks at an exercise price of $10 per share, and the market value of the stock later skyrockets to $200 per share, you can exercise your option to buy the stock at $10 per share, then sell it at $200 for a nice $190 profit per share.

Of course, in order to exercise your option in the first place, you need to have $10 per share that you are willing to spend upfront. That may not sound like much, but it can add up fast. If you have one hundred shares, for example, you will need $1,000 in order to exercise.

Furthermore, as the share price increases, so do the investment and risk for the option holder. That is why a cashless exercise, or same-day sale, can come in handy.

Can you exercise an option and sell the same day?

A cashless exercise is when the exercising of an option and the sale of the stock are combined into one transaction, thus eliminating the need to first purchase the shares by using the profit of the sale to cover the cost. This is usually facilitated by a brokerage firm, which essentially extends a loan to the option holder and uses a portion of the proceeds of the sale to repay themselves for the loan.

From the point of view of the option holder, they simply receive the difference between the share price and the sale price. To demonstrate how it works, let’s continue to use our example from above. If you have the option to buy one hundred shares at $10 per share, and the market value of the stock is now $200 per share, a cashless exercise would yield you a $19,000 payout without having to put up your own cash.

It’s a simple, convenient, and low-risk strategy. However, it is not perfect.

What are the drawbacks of a same-day sale?

If the idea of a same-day sale or cashless exercise sounds too good to be true, you’re right. There are some major drawbacks you’ll need to keep in mind before deciding whether or not this is the right strategy for you.

First, the “bargain element,” which is the difference between the exercise price and stock value, is taxable to you as wages at ordinary income rates, which can be as high as 52.65% if you live in California, factoring in both federal and state taxes.

Second, if you plan to use a cashless exercise, you will need to stay with the company until the IPO or acquisition. Otherwise, if you leave sooner, you will have to exercise your stock options upon your departure. Considering how long it takes for many startups to exit, a cashless exercise may not be possible for many employees.

How are cashless exercises taxed?

As the high tax rates can be one of the most expensive and unexpected aspects of a same-day sale, it’s important to understand in advance that your profit may be significantly minimized.

On the other hand, if you exercise your option and wait at least one year before selling, you will be able to take advantage of a lower long-term capital gains rate, thereby increasing your gains. Likewise, if you believe your company’s stock value is likely to increase very quickly, it may be advantageous to exercise your option early. It all depends on your circumstances.

Another tax consideration to keep in mind when considering a same-day sale: due to an unusual quirk, the proceeds of the sale are reported to you twice — once as taxable wages and again as proceeds from a stock transaction. Every year, taxpayers get bills for a balance due from the IRS because they did not properly report proceeds and basis from stock options in addition to their income on Form W-2.

Drawbacks aside, there are nevertheless excellent reasons to consider a same-day sale. If you don’t have the funds to buy your shares upfront, or you don’t want to risk losing your investment if the company does not successfully exit, you may want to ask your financial advisor if a cashless exercise is the right choice for you.

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