One might say that they fall right in the middle of these two.
From a tax standpoint, gains are subject to ordinary income tax rates. In terms of control, employees have the ability to time the exercise of their non-qualified stock options.
Exactly when and how decisions regarding non-qualified stock options are implemented may have a material impact on the after-tax wealth that is generated.
Let’s explore a bit further…
The day you receive non-qualified stock options is known as the grant date. The grant date sets the schedule for the remaining key dates in the lifetime of the stock options.
On the grant date, the recipient receives employer stock options. The shares are also given a value on this date that is known as the exercise price. The exercise price is the price at which the employee can purchase the shares of stock.
The grant date is often not the time when the employee can take action on non-qualified stock options. Options are typically subject to a vesting schedule.
Non-qualified stock options are issued with a vesting schedule. Prior to shares meeting the vesting requirements, the employee has no ability to act on the options.
Once the vesting period is met, the employee gains control, allowing them to exercise the shares if they so choose.
Over time, the price of the employer stock price will fluctuate up and/or down. If the price of the employer stock exceeds the exercise price, then the options are “in the money” and have value. If the price is less than the exercise price, then the options are worthless.
In practice, shares could presumably be in the money (with the stock price being higher than the exercise price), yet the employee may not be able to act if the vesting schedule hasn’t been met. Once the options vest, this in the money option immediately becomes a real asset.
Shares are also issued with an expiration date. This is a date when the shares expire if the employee does not take any action to exercise them.
If the shares are worthless (the stock price is below the exercise price), it would make sense to let them expire. If the shares have value, the expiration date would be the final date on which an employee could exercise the shares.
Options for Exercise
The hope with stock options is that the price of the stock appreciates above the exercise price of the options. If shares are vested and the stock options are in the money, the employee has “real” value. At this point, a decision must be made:
If you do nothing, the value of the stock price can and will fluctuate. If the price continues to appreciate, your stock options become more and more valuable. However, if the price goes down, you could lose a substantial amount of money.
Electing to Exercise
If you choose to exercise your options, you must address a few key questions:
- Will you choose a cash exercise or a cashless exercise?
- A cash exercise will require the employee to pay cash to buy the shares. This requires access to the amount of necessary cash.
- A cashless exercise will utilize some shares to purchase the others. It will not require a cash outlay from the employee.
- Do you plan on holding the stock after the exercise of the options?
The answers to these questions may impact cash flow, tax impact, and overall investor asset allocation or risk profile.
Taxability at Exercise
Prior to exercising non-qualified stock options, no taxes are due. In effect, any tax liability is suspended until a taxable event occurs. Upon exercise, taxes become due.
Taxes for non-qualified stock options are similar to restricted stock. All gain is taxed as ordinary income to the recipient. One key difference is that with non-qualified stock options, the employee can control the timing. With restricted stock, the taxable event occurs immediately upon vesting.
For example, let’s assume 1,000 options with an exercise price of $15 and a market price of $100. Upon exercise, the employee would be required to report $85,000 of ordinary income on their tax return:
- 1,000 shares x ($100 – $15)
Taxability after Exercise
Assuming that the shares are held after exercise, the employee stock will have a basis equal to the stock price on the date of exercise. In the example above, each share will have a basis of $100.
If these shares appreciate further and are subsequently sold, any gain/loss will be subject to capital gain/loss rates. This leaves the potential for possible preferential long-term capital gain treatment.
So What is the Best Strategy?
As with all employer stock and stock options, the optimized method for exercising non-qualified stock options is very difficult. With so many variables, it’s difficult to identify the best option.
However, there are several strategies that can be implemented to exercise non-qualified stock options based on an employee’s goals and objectives. These options may include:
- Exercise and sell immediately, effectively treating stock options as another form of compensation.
- Exercise and sell at or near expiration. This is commonly a default option for many people.
- Exercise early and hold. This is an option for someone who is bullish on company stock.
Which one is right for you may require advanced planning and the help of an expert.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. None of the information in this document should be considered as tax advice.
The above figures and examples are hypothetical and are for illustrative purposes only and do not attempt to predict actual results of any particular investment.