Stock Option Taxation

In this piece, we will discuss stock option taxation, the different types of stock options, and all the details pertinent to an employee stock option plan.

After setting up a company and the hiring process, employers have to think about different ways to compensate their employees. Many companies tend to offer equity compensation to the workers, but it is important to know about the compliance and tax rules they will need to follow. For those who don’t know, there are different stock option plans to choose from, and each plan has different obligations, forms, rules, tax effects etc.

Therefore, before anyone plans to go ahead with their startup, they must familiarize themselves with stock options and how their taxation works. In this piece, we will discuss stock option taxation, the different types of stock options, and all the details pertinent to an employee stock option plan.

Stock Option

Most of you reading this may have seen your colleagues exercise stock option tax and wondered what a stock option really is. At its core, a stock option acts as a contract between parties that gives the purchaser the right to buy or put their underlying stock for sale at a preset rate. Here is a close look at what a stock option is all about.

What is a Stock Option?

Stock options are a renowned form of alternative compensation used by thousands of companies (especially startups) in their employee packages. It is a great way to land talented, highly skilled employees at lower than market salaries in exchange for a potentially massive payday down the line. Most job applicants these days receive options for their compensation packages and those who accept them often don’t know how to exercise them.

To make things really simple, stock options are a type of compensation startups offer to consultants, contractors, employees, investors etc. They are essentially contracts that give workers the right exercise or purchase a specific amount of shares from the company’s stock for pre-determined prices (aka grant price).

That said, this offer has an expiry date and you must utilize them wisely, making the most out of it. Some employers even require their employees to exercise their options after departing from the company, within a pre-determined period.

Stock Option Key Terms

There are several stock option key terms that you must familiarize yourself with. Knowing them will allow you to make well informed decisions and avoid confusion when you receive and exercise them. Furthermore, it will prove to be quite handy when you vest your options later on, as you will know the exact purpose a particular term serves.

  • Call Option: Traders buy a call option if they think the price of an underlying option would increase within a particular period. When it comes to the options used in the United States, call options are contracts that offer buyers the right to purchase underlying assets for set prices before the expiry date. On the other hand, if someone ends up with a Europe styled option, they may exercise it for purchasing the underlying at the exact date of expiry.
  • Put Option: A trader will buy a put option if he or she expects the underlying asset’s price to fall in a particular time frame. It would be fair to say that put options are exactly opposite to call options. The United States style put options give buyers the opportunity to sell underlying assets for a set price whenever they please, as long as it is before the expiration date. However, anyone who buys European style put options can only exercise them on the expiry date. In this case, the strike prices are determined beforehand, and put buyers will be well within their rights if they decide to sell their underlying asset. Exercising the option can only be worthwhile if the underlying current price is lower than the strike price.
  • Strike Price: Strike prices are the particular rates at which one can buy or sell a derivative contract when exercising it. In call options, the option holder can buy the security. On the other hand, you can sell the security when it comes to put options. In most cases, companies utilize strike prices in derivatives. For those who are unaware, derivatives are essentially financial products, the values of which depend on underlying assets.
  • Expiration Date: In stock options, an expiration day is the last day when you can exercise your option. Before the expiry of options, the individual who owns it can either exercise it, close their position for realizing loss or profit, or they can let their contract simply expire. That said, expiration dates can represent different things depending on derivatives.
  • Premium: In stock options, premiums represent a contract’s current price in the market. Therefore, it becomes the income obtained by the writer or seller of a contract to any other party. Stock option premiums consist of two main factors, which are: extrinsic value and intrinsic value. Also, the stock option premiums cost a dollar per share. Most contracts have a one-hundred share commitment. Investors who lean more towards selling, puts or calls, utilize premiums as the main source of obtaining current income along with a wider investment strategy for heading an entire portfolio or at least a portion of it. It is also worth noting that an option premium’s components include time value, intrinsic value, and most importantly, the underlying asset’s implied volatility.
  • Underlying Asset: The main purpose of an underlying asset is to give value to derivatives. For example, a stock option offers the holder the opportunity (the right) to sell or buy ABC at a strike price until the date of expiration. Underlying assets come in incredibly handy for identifying any item in the agreement that adds value. What’s more, underlying assets are essential for the agreement’s security, which parties agree to exchange in accordance with their contract. It would be fair to say that an underlying asset acts as a security that an option seller must deliver or buy from the holder in case they decide to exercise the option. With stock options, people use the term “underlying assets” when talking about a specific company’s shares.

How Stock Options Work

A listed options price is closely connected to the underlying stock’s price movement. If the stock’s price rises or falls, the option, in most cases, moves towards the same direction. Options are vastly different from stocks in the sense that you trade stock options as a contract where a single contract covers one hundred shares.

As discussed, the main purpose of stock options is to incentivize highly skilled employees, giving them the possibility to own the company’s stock for discounted prices rather than purchasing it on the open market. Retaining employees who received stock options from the company is possible through a popular technique known as vesting.

Vesting is a great way for employers to encourage workers to remain with the company until the vesting period is over, as that is the only way they could get the shares offered to them. Put simply, you will not own your options until you meet the vesting schedule’s particular requirements.

Exercise Stock Option

Knowing the right time to exercise stock options, and most importantly, how to exercise it can be quite difficult for first timers. This can often depend on when the options were granted and how long the vesting period is. It’s also important as when you exercise your stock options, you normally need to pay tax.

Mentioned below, are some tips that can help you understand how and when to exercise stock options.

When to Exercise Stock Options?

When thinking about the right time to exercise your stock options, you need to remember the considerations mentioned below in mind. Doing so will allow you to exercise your options at your preferred time without compromising your gains.

  • Cashless: You buy your shares and sell them right away. In several situations, your broker will have no trouble allowing you to use your own cash for this transaction. The best thing about this choice is that it lets you utilize your cash for other investments or any other way you deem fit.
  • Cash for Stock: You buy option shares using your cash and keep hold of them. Doing so allows you to make maximum investments while offering you a high potential to obtain more gains from improvement in stock value. That said, you may have to deposit the cash to your brokerage account. In addition, you may have to pay brokerage taxes, commissions, and fees.
  • Cashless (Covering by Exercise and Selling): In this situation you can exercise the option followed by immediately selling enough shares for covering commissions, taxes, fees, and purchase price. The proceeds resulting from it will remain as company stock.

How to Exercise Stock Options?

You can exercise your options as soon as they vest. This also means that you can buy the company stock’s shares. Remember, your options will not be of value unless you exercise them. The price you will need to pay for these options will be present on your contract. So, make sure you read it thoroughly to avoid any confusion later on.

The best thing about exercising stock options is that the price written on the contract remains unchanged. For instance, you spent four years at the same company and you have around 20,000 stock options with a $1 exercise price. To exercise your options, you will have to pay $20,000. After exercising, you will become the owner of the entire stock and you can sell it whenever you please.

In addition, you can also choose to hold it and wait for the stock prices to increase down the line. However, you will also have to pay fees, taxes, and commissions associated with selling and exercising your options. You can also use some tried and tested techniques to exercise your stock options without worrying about using the cash for buying all of the options.

Remember, no matter which type of stock option you possess, it comes with an expiration date. It is present in your contract and details other intricacies about your stock option agreement too. Commonly, options tend to expire within ten years from the date the company grants them to the employee.

Types of Stock Option

You have to pay taxes whenever you sell or exercise your stock options. The amount of pay greatly depends on the type of options you possess and the amount of time you waited between selling and exercising. There are two main stock option types and their taxation methods are quite different. Let us discuss what makes them so unique from each other.

ISO or Incentive Stock Option

Companies mostly give incentive stock options to executives. ISOs can only be given to employees in the company, and cannot be issued to any other service provider. Because of this, these types of options give preferential tax treatment in form of long term capitals gains rates. With ISOs, employees don’t have to pay tax for exercising their options and the company that offers it doesn’t have to face deductions either.

NSO or Non-Qualified Stock Option

Non-qualified stock options are arguably the most popular option. This type of stock options can be issued to any type of service provider for the company, and is not limited to the company employees. Therefore the company can issue it to advisors, lawyers, investors, founders, employees, and others. Unlike Incentive stock options, the federal government does not offer NQSOs special tax treatment.

Taxation of Incentive Stock Option

Incentive stock options are reported twice for tax reasons. The first is when you exercise them and the second is when you sell them. While you may not be paying tax during these two events, the timing of these play a factor on how much tax you may pay in the end. Their taxation when someone sells them depends on the particular sale’s qualifying disposition criteria.

The initial event with incentive stock options happens once you exercise them. ISOs count as income when you exercise them only to calculate AMT. It is also worth keeping in mind that the stock’s sale obtained through Incentive Stock Options should be reported for alternative minimum tax. Your sale’s taxation depends on the amount of time you held your shares.

Taxation of Non-Qualified Stock Option

With non-qualified stock options, when you exercise your specific option by buying stock, the fair market price and exercise price’s difference gets taxed as regular income. However, if someone sells their NSO, they will have to pay taxes for realized capital gains. This is also taxed as regular income, and thus subject to the higher tax bracket as compared with ISOs.

Want to know how Stock Option taxation affects your Company?

Now that you know the ins and outs of stock option taxation and how stock options work, exercising them won’t be a problem. However, you can take a professional approach and use a high-quality equity management software like Eqvista. It can issue and manage stock efficiently, making sure that you can gain maximum benefit before it expires.

To know more about how to use our platform for your company’s stock options, visit our Support Guides, or contact us today!

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