Stock options are a common form of compensation and are used as an incentive to attract (and retain) top talent. Their value depends on current share prices and can drastically affect the total compensation an employee receives from his/her company. With the current swings in the market, the potential gains on options can be huge.
What Are They?
Employee stock options are given by a company to its employees and give the employees the right to buy the company’s stock at a specific price for a certain time period.
They are seen as a ‘long term’ incentive because they typically vest (become available for use) over a longer time period. They vest in increments over a period of years, such as 1/3 per year for the following 3 years from when they are granted.
Most options have an expiry period several years from when they are granted. After they expire – they can no longer be used, regardless of the stock price.
The price that the options are granted at is called the ‘exercise price’. It is usually determined using the average price from a prior period, such as the last 5 trading days.
If the share price rises above the exercise price after the options are granted, the options are ‘in the money’. If the share price goes below the exercise price after the options are granted, the options are ‘out of the money’.
Taxes on Employee Stock Options
When an employee is granted options, they are given the option to buy the stock at a specific price (the exercise price).
The difference between the current value of a stock and the exercise price is considered a capital gain and subject to 50% taxation.
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Note – the options become taxable when they are exercised, not when they are granted.
For example: John owns 500 options to buy shares of ABC Co. at $15/share. The stock currently trades at $22/share. If he exercises the options now, he would have a capital gain of $3500 ($22-$15 x 500 shares) – and half of this would be taxable. The other half is not taxable.
There are a couple different strategies involved with employee stock options regarding the timing of exercising and related tax consequences.
Strategy 1: Exercise the options when the exercise price is below the current price of the stock (and hold). Since the taxes are paid when the options are exercised, in this case there would be no taxes payable. This is done in the hopes that the stock rises in price after being exercised.
For example: Let’s say John exercises options in ABC Co. for $5/share. The stock currently trades for $3/share. At this point the options are not ‘in the money’. He would not be subject to taxes when the options are exercised because the exercise price is below the current market price of the shares. John would be betting that the stock will rise in price over time.
Strategy 2: Exercise the options when the current share price is above the exercise price and sell immediately – triggering a capital gain. This is ideal if the exercise price is below the current price of the shares.
For example: Let’s say John has 500 options to buy shares in ABC Co. for $5/share. They currently trade at $11/share. The capital gain is $6/share ($11-$5) and is subject to 50% taxes at John’s marginal tax rate. The other 50% of the gain is not subject to tax. This strategy is less risky and ensures a gain is locked in at a certain price.
Strategy 3: Exercise options strategically. This strategy attempts to match any taxable capital gains resulting from exercising options with any capital losses incurred in the same year.
For example: Let’s say John has 500 options to buy shares of ABC Co. for $12/share. The current share price is $17. The taxable capital gain is: $17-12 x 500 shares = $2,500 x 50% taxable = $1,250. He also has $1,250 in capital losses from shares he sold at a loss. He could apply these losses against the capital gains to eliminate any taxes payable.
Benefits of Stock Options
– When granted, they do not subject the employee to any market risk. They can basically wait until the stock rises in price, and then exercise the options when they will realize a gain
– They are used as a motivator for employees to try to ensure long term success for a company. The higher the stock price goes, the more gains the employees can make (assuming they hold stock options)
– Depending on the company, stock price and number of options, they can be very lucrative for employees and can sometimes exceed an employee’s salary for overall compensation
– They can be beneficial for smaller companies because they don’t require an upfront outlay of cash. Potential employees of smaller, startup companies view them as a great incentive because they can potentially become very lucrative
Who is Exercising Their Options?
Click here for a site that shows the insider activity for each company, including exercising of options
Conclusion: Employee stock options are usually a key form of compensation for public companies and are used to attract top talent. The difference between the current share price and exercise price is a capital gain (of which half is taxable).
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