Corporate America has relied upon employee stock option plans as a valuable incentive program which aligns the company’s financial performance with employee compensation. Employees stock options are a form of non-cash compensation that employers offer to employees the option to purchase company stock at a specific price in the future. The two basic types of stock options are qualified and non-qualified. Most employee stock options are non-qualified because employers can be selective towards which employees receive stock option grants. When you exercise non-qualified employee stock options, you must realize any gains upon the option exercise as W-2 income and subject to ordinary income tax rates. When you exercise a qualified employee stock option any gains are not taxed until company stock is sold.
Stock Holding Period Matters
When you exercise your non-qualified employee stock options, you receive company stock that can be sold at anytime. If you exercise and hold the company stock after exercising your options, you must realize as taxable income the difference between the grant price and the exercise price. On the other hand, when you exercise your qualified employee stock options, the gains you realize are eligible for special tax treatment, and employees do not have to realize any gains upon exercising their stock options as income. For both type of stock options, when you sell the acquired company stock will determine the capital gains tax treatment. The capital gain for holding periods in excess of 12 months will be taxed at a more favorable tax rate, than shorter holding periods.
An Example
The amount of taxable compensation for non-qualified employee stock option plans is the difference between the grant price and the market price on the day your options are exercised. For example, assume your non-qualified employee stock option has a grant price of $15, the market price on the day you exercise your shares is $20, and you exercised 200 shares. The taxable compensation is the difference between the grant price and the stock price, multiplied by the amount of sold shares. In this example, $5 times 200 equals $1,000 in W-2 income. For qualified employee stock options plans, tax is not paid upon exercise, but when the stock is sold for the difference between the grant price and sales price. For holding periods in excess of 12 months, the lower capital gains tax is paid.
Economic Rationale vs. Emotional Attachment
Many employees whose economic well-being is tied to their company’s fortunes do not recognize their emotional attachment to their company stock. As the value of an employee’s stock option grants grow there is an increased correlation between the company’s wealth and the employee. Economic theory recognizes that an employee’s financial reliance on their company increases exponentially when their employment income is considered. This recognition leads to the economic rationale that will require employees to avoid concentrating their financial assets in their company stock. As a general rule, a substantial portion of employee stock option grants should be exercised, sold and diversified into financial assets other than their company stock.
