As another option for compensation, many employers have added company stock plans as an employee benefit to promote loyalty and increase compensation. If you are reviewing your company’s benefits or considering a new position, it will help to understand the basics of the most common stock option plans. We have created a cheat sheet to help guide you to know what these options are and what questions to ask.
Nearly all stock option plans will use specific terminology when describing the benefits and the process to realizing these benefits. A few terms to look for when reviewing your company’s benefits:
Qualified or Non-Qualified: This will alert you to special tax-incentives when receiving and exercising these options. If a plan is qualified, it provides additional tax-incentives to keep more of the benefit in your pocket.
Plan Type: It is important to understand what the defined plan type is. This established the basic frame-work for how the options will work.
Grant: This term explains the details around the stock offer. There is usually a grant price and a grant date notated on every offer. Most option plans will be taxed based on the grant details.
Exercise: This term basically means when and how do the options become actual shares of stock or cash or when do they become real assets for you.
Vesting: To promote loyalty, several employers will add pre-specified waiting periods, known as vesting periods, to receiving your stock benefits. These vesting periods can be gradual over several years (i.e. 20% per year for five years) or all at once, known as a cliff-schedule (i.e. 100% available on the third anniversary of the grant).
Taxation: One of the major considerations in maintaining your stock option plan. The taxation rules around the various stock option plans differ and can be quite confusing. When you add the unknown of the future stock values, you have quite a puzzle on your hands.
Here are a few of the most common plan types that employers offer to employees:
Incentive Stock Options (ISO):
Summary: A type of qualified plan that offers the most favorable taxation. These are not offered as frequently any longer.
Grant: A number of shares are offered to the employee for purchase at a specified exercise price.
Exercise: When you choose to purchase the stock shares at the price offered upon the stock grant, it is considered exercising. Typically, the exercise price is lower than the current market price of the stock.
Taxation at Exercise: The difference between the exercise price and the current market price is considered the bargain element, and will ignored from income tax calculations. (If you are subject to AMT, this income will not be ignored.)
Taxation at Sale: If treated properly, a qualifying sale of ISOs will be taxed at Long-Term Capital Gain tax rates. The tax will be on the difference between the selling price and the cost of the option. A qualifying sale requires that the shares are held more than two years from the grant date and more than one year from the exercise date.
Non-Qualified Stock Options (NSO):
Summary: Non-Qualified options that allow for the purchase of stocks at a discount.
Grant: A number of shares are offered to the employee for purchase at a specified exercise price, usually the current market price on the grant date.
Exercise: When you choose to purchase the stock shares at the price offered upon the stock grant, it is considered exercising. Typically, the exercise price is lower than the current market price of the stock.
Taxation at Exercise: The difference between the exercise price and the current market price is considered the bargain element and is reported as ordinary income. The exercise price is now your basis in the stock holding.
Taxation at Sale: The growth over the exercise price is taxed at capital gains rates; either short-term or long-term.
Restricted Stock Options or Units (RSO/RSU):
Summary: A compensation benefit valued in terms of company stock, but no stock is available at the grant date.
Grant: A number of shares are offered to the employee for purchase at a specified exercise price or vesting date.
Exercise: When you choose to purchase the stock shares at the price offered upon the stock grant, it is considered exercising. This can be synonymous with the vesting date if the strike price is $0.
Taxation at Exercise: The difference between the grant price and the current market value will be considered ordinary income.
Taxation at Sale: The growth over the exercise price is taxed at capital gains rates; either short-term or long-term.
Stock Appreciation Rights (SAR):
Summary: Provides the company the ability to share the appreciation of the company stock with its employees. Sometimes considered ‘phantom’ stock options.
Grant: A specific value of shares is promised to the employee with a specific exercise time frame.
Exercise: At exercise, cash or sometimes shares of stock are delivered to the employee. It doesn’t require the employee to finance the exercise payment.
Taxation at Exercise: The value of the stock or cash delivered is ordinary income to the employee.
Taxation at Sale: The growth over the exercise price is taxed at capital gains rates; either short-term or long-term.
Employee Stock Option Plan (ESOP):
Summary: A benefit that contributes company stock into your retirement plan. This can be used to pay cash back to the owner of the business as a form of buyout measures.
Grant: These are contributed at the employer’s discretion.
Exercise: While there may be vesting, there is no required exercise. Once vested, the employee owns the shares out-right.
Taxation at Exercise: The taxes are usually deferred through a retirement plan, such as a 401(k) plan.
Taxation at Sale: Once the stock is distributed and sold, all of the proceeds will be subject to ordinary income tax rates.
Employee Stock Purchase Plan (ESPP):
Summary: This plan gives eligible employees the opportunity to buy shares of the company at regular intervals and usually at a discount.
Grant: There are specific purchasing intervals established by the plan. An employee wishing to participate needs to sign-up and contribute via payroll deductions prior to each interval.
Exercise: Depending on the plan, these purchasing intervals are usually set a few times per year.
Taxation at Exercise: No taxes are due until the sale of the shares
Taxation at Sale: In order to get the most favorable tax treatment, the stock will need to be held at least one year from the purchase date and two years from the offering date.