Below you will find answers to the following questions:
● What are employee stock options?
● What are the different types?
● How are they taxed?
● What are some common considerations in the decision-making process?
Think of employee stock options like a coupon to buy gas for your car at $2.00 per gallon. If gas prices skyrocket to $4.00, your $2.00 coupon would come in handy and be quite valuable. If gas prices sink to $1.00, the coupon becomes temporarily worthless. The coupon could expire in the future and end up in the trash, unless gas prices jump back up.
An employee stock option, like a coupon, gives you the option or choice to purchase stock in the future at a fixed price. You are never required to use the coupon. And just the fact that you are given a coupon doesn’t mean much, as you actually have to act to realize the value. Leaving it at home while you go to the store wouldn’t do any good.
Stock options are one of the most common ways to compensate employees of private companies. Growing companies who have limited funding or revenue generally can only pay so much in salaries. Stock options could provide employees with bigger upside, and make employees have more “skin in the game”, which is believed to be valuable from a company perspective. Sometimes stock options end up being worthless. Other times they are worth something. Sometimes they can be worth a lot.
The two types of employee stock options are: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs or NSOs).
Usually, most people know whether they have stock options, but it is not typical for someone to know exactly which type of stock options they have. Below are a few key differences between the two so that you can be better informed about your compensation.
One of the first differences between stock option grants is when they are granted. Using an IPO or "going public" as the finish line of a metaphorical marathon, ISOs are generally given out at earlier-stage companies (mile 1 through 8). If your company is in the “mid-stages” it is more likely that you are receiving NQSOs (mile 9 through 16). The closer your company gets to a potential IPO the more likely they are to stop issuing options altogether and begin offering RSUs, or Restricted Stock Units (mile 17 through 26).
If someone does not know what type of options they have, the stage of their company is usually a decent indicator. If they have been at the company for 4+ years pre-IPO, they could have multiple types of equity compensation. The exact type is ultimately determined by reviewing a copy of their grant paperwork.
How are these options taxed?
When looking at the names of the two types of options it is easy to guess which one is taxed less favorably, and which one is taxed more-favorably. Incentive (ISO) vs. Non-Qualified. Without knowing anything, you would guess the one titled "Non-Qualified" is taxed in a "worse" way. Usually, you want to qualify for things. In this case, it means "Not Qualified for Special Tax Treatment."
To explain the key differences in taxation we will try to use two real life examples that apply to a lot of people.
Grocery Store Shopping:
Imagine you found a coupon from your favorite grocery store. The coupon said, "Buy Organic Eggs for Only $5". Notice that the coupon does not specify the discount amount in dollar terms ($2 off), or percentage terms (15% off). Instead, it only states the price at which you can purchase the eggs. Given this, you would be very curious to see what the retail price of the eggs is.
(The paragraph above is a key point in thinking about stock options. Employee Stock Options are a right to purchase a share of a company at a fixed price. Not a specified discounted amount or percentage. You may be familiar with ESPPs which involve a discounted percentage, usually 15%. Stock options are about a fixed price.)
Next, you walk in the store to check the price, and you see that your favorite eggs are $8. Bingo, this is a great coupon. You grab the eggs and buy them for $5 using the coupon. Almost a 40% discount off the regular price.
Immediately after your purchase, right as you are walking out of the store, there is a tap on your shoulder. It is Uncle Sam.
Uncle Sam believes that the $3 discount you received should be treated the same exact way as earning $3 of income since you received an "economic benefit" of $3. Now, thanks to Uncle Sam, you owe taxes on the $3 of "income" - which might amount to a tax bill of $1 to $1.50 depending on your personal situation. What if you don't have $1 or $1.50 in your pocket to pay in taxes? You may need to borrow money, sell a few eggs, or find another way to come up with the cash.
The above scenario does not seem totally fair. Have there been any other times in your life where you’ve been taxed on a discount? After all, you didn't earn $3 of income, all you got were some discounted eggs. This is the Non-Qualified Option.
Exercising Options are like cashing in a coupon at a store. If you exercise a Non-Qualified stock option by purchasing the stock of your employer, the "discount" amount is considered taxable income in that tax year. It doesn't matter if you hold onto the stock or if you sell it. The discounted purchase creates an "economic benefit" that is considered income.
(Note: If your company is not publicly traded, the price (or fair market value) of your company stock is usually determined by a 409A valuation. If you are unsure of where to find this information, check with your Finance/HR department.)
Imagine the same grocery store scenario above, except when you purchase the eggs for $5 and walk out of the store, there is no shoulder tap. There is no Uncle Sam.
Later that day you go and sell the eggs to your neighbor for $7. You actually profited $2 in this scenario. This is a point where you feel a tap on the shoulder, it is Uncle Sam. It never feels good to see Uncle Sam, but this situation is less upsetting since you received $2 of profit and actually have $7 of cash in your pocket. You are OK with paying taxes on your gain.
The above scenario seems much more fair than the first. This better scenario is the Incentive Stock Option.
(There is an additional layer of complexity with exercising ISOs and holding them related to AMT, or Alternative Minimum Tax, which we've covered in this article.)
For the most part, anything that you sell for more than you bought it for will result in a tax bill. Or should result in a tax bill if you report it. An ISO is no different.
Let’s try one more example to better understand.
Cars in the Family:
Your Uncle gives you his old car to drive (let’s ignore gifting laws for a moment). The car is worth $10,000 but he just gave it to you for free. You acquired something worth $10k but paid $0.
In a NQSO world, you would have to pay taxes on the $10,000 of “economic benefit.”
In an ISO world, you are not taxed until after you sell the car. If you sell it to your friend for $9,000 because you need rent money, you now have taxable income of $9,000.
We covered a grocery store and a car example, and now let’s take a look at an actual stock transaction.
Let's say Starbucks is valued at $50 per share. You are given the option to buy Starbucks at $50/share anytime in the next 10 years.
If the stock never goes above $50, you will never exercise the option. Why would you buy it for $50 if you can buy it on the stock market for less than $50? You would never buy the eggs for $5 when you can buy them for $3 next door. You would never use the $2.00 gas coupon when you can get gas for $1.50 without the coupon.
If the Starbucks stock goes up and up, and is now valued at $100, it may make sense to exercise it. Why wouldn't we buy something worth $100 for only $50, when we can turn around and sell it for $100? An instant $50 profit.
When you buy the stock for a discount, you are taxed on the economic benefit if it is a Non-Qualified stock option. You were taxed on your $3 discount on the eggs and you would be taxed on the $50 discount on Starbucks stock, in a non-qualified world.
For an ISO, again, you will not owe taxes until you sell it (still ignoring potential AMT implications).
Private Companies
Keep in mind that you generally are unable to sell shares of stock if your company is private. With a public company you are able to sell shares in order to pay for the cost of exercising without using your own cash (a “cashless exercise”). With a private company, you generally need to fund the cost yourself.
More on Tax Treatment
If you exercise your ISOs in one year and sell the shares for a gain within a year or within two years from the grant - your tax treatment (tax rates) will be similar to the tax treatment of an NQSO. It will be treated as ordinary income and is called “disqualifying disposition”. No preferential tax rates, though they won’t be subject to payroll taxes.
The big upside with an ISO is this: If you sell at a gain after holding it for over a year (after you exercise) and two years from the original grant date, the gain is taxed at a lower tax rate known as long-term capital gains rate. This is the “qualified disposition” that carries the "special" or "preferential" tax treatment. This is what you "qualify for" with an ISO.
The key is that all of the growth and the initial "discount" received is eligible to qualify for the lower capital gains rate. If the carton of eggs you got for $5 were suddenly worth $20, your total gain would add up to $15. $12 of that is due to appreciation and $3 can be attributed to the initial discount you received with your “coupon.”
How much of a tax discount do you get with a “preferred rate? It depends on your specific tax situation, but it usually ranges from 5% to 15%.
That sounds great. Why wouldn't you exercise and hold the ISO for a big tax discount?
A bird in the hand is better than two in the bush.
Buying Starbucks for $50 when it is worth $100 sounds amazing. But, if you wait 12 months to sell (holding out for a lower tax rate) and the stock price drops to $40, then you would end up losing money. The person that sold it right away - they ignored the possibility of a special tax rate to lock in a guaranteed gain. A 50% tax rate on some income is better than a 0% tax rate on no income.
Additional reasons to not hold out for a lower tax rate are personal. They usually center around liquidity needs, concentration risk, and personal financial goals.
If someone needs the money for a particular reason, then the tax rate is less important. For many, life-changing money at a higher tax rate is still life-changing money. Would you take a guarantee of $5 million dollars today, or hold out with the hopes that it is worth $6-10 million in 12 months, knowing that it could end up at $0? Other liquidity needs are more goal specific such as a house purchase or a tuition payment.
Concentration risk is also a factor. If 90% of your net worth is tied up in one company, you may be more interested in reducing that percentage, “de-risking” or becoming more diversified. That doesn’t mean selling everything, but it may mean selling “some” in order to sleep better at night.
We hope that you found this helpful, and that your understanding of employer stock compensation is better after reading this. If you have any additional questions around stock options, feel free to poke around the blog, send us an email, or schedule a time to chat.