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Employee Stock Options
What are Stock Option Plans?
by InvestorGuide Staff (Write for us!)
(Click on the links within the article to get definition of that word)
Employee ownership has grown greatly in popularity over the last decade, and the growth is
expected to continue. There are two types of arrangements through which employees can gain partial ownership of their employer's company and share in its growth: stock ownership plans and stock option plans. The two are similar but not identical, so it's worthwhile to look at each in turn.
An employee stock option plan gives you the right to buy a certain number of shares of
your employer's stock at a stated price (called the grant price, strike price, or exercise price) over a certain period of time (for example, ten years). Nearly all stock option plans are offered by companies which are publicly traded or which will soon go public. In many cases, the shares "vest" over a period of several years, meaning that some fraction of the shares can be exercised in the first year, another fraction in the second year, and so on. Whenever the option's exercise price is above what the stock currently trades for, the option is "in the money". Otherwise, it is "underwater".
For nonqualified stock options, you usually don't owe any taxes when the options are granted, but payordinary income tax on the difference between the exercise price and the current stock price value when you exercise the options. Companies can deduct this amount as a compensation expense. Any subsequent appreciation in the stock is taxed at capital gainsrates when you sell the shares (which is more favorable if
you hold for at least one year). They can be granted at a discount to the current stock price, and they are transferable to children and charity (provided your employer allows it).
For incentive (or "qualified") stock options (ISO's), no income tax is due when the options are granted or when they're exercised. Instead, the tax is deferred until you sell the stock, at which time you are taxed for your entire gain. As long as you sell at least two years after the options were granted and at least one year after you exercised them, you'll be taxed at the lower, long-termcapitalgainsrate; otherwise, the sale is considered a "disqualifying disposition", and you'll be taxed as if you had held nonqualified options (the gain at exercise is taxed as ordinaryincome, and any subsequent appreciation is taxed as capital gains). ISO's may not be granted at a discount to the current stock price, and they are not transferable, except through a will.
There are three basic ways to exercise your options:
Pay cash: This is the simplest technique.
Stock swap: Some employers let you trade company stock that you already own to acquire option stock. Since the exercise price is below the stock price, you will get more shares than you give up.
Cashless exercise: In this technique, you borrow from a broker the amount you need to exercise your options and sell just enough of these shares to cover the costs. You receive the difference in stock or cash.
Please note that
this section is intended as only a very basic introduction to employee stock and option plans. The topic is complex and there are a large number of rules that must be followed in order to avoid penalties and maximize the benefit to you. If you are participating in a stock ownership plan or stock option program, or if you have shares or options from a former employer, we strongly encourage you to learn more and consider talking to a financial or tax professional before making any major decisions .
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