How to handle stock options

March 28, 2014

Recently, I wrote a financial plan for a client who had stock options. This is a complicated area because it includes taxation, market and concentration risk, public versus private company, et al. However, to sum it up in the words of Ronald Reagan, “Mr. Gorbachev. Tear down that wall.” No, that’s not quite it. Let’s try again, “Mr. Gorbachev. Exercise those options.”

Why? One reason is 2008.

Let me begin by explaining some stock option basics before we get to the 2008 example. What is a stock? It is ownership of part of a company. What is an option? It is the right to buy or sell stock at a predetermined price. As an example, you work for IBM and they give you a grant which is an option to buy the stock at $100. The stock is currently trading at $183, so if you exercise your option, you buy the stock for $100 and you put $83 in your pocket. That’s it; pretty simple.

However, like most things in life, it gets complicated in the real world. In the above hypothetical example, the strike price was $100 and the market price was $183, so the option was “in the money” because the strike price was lower than the market price. And, there was no vesting, vesting schedule, nonqualified options, incentive stock options or complicated tax implications as there are in the real world.

Let’s talk about the real world. First, we must differentiate a stock option from a public versus a private company. Public companies are traded on an exchange. Private companies are not. So, if you are given stock options from a public company, you can exercise them and sell the stock. Because a privately owned company is not traded on an exchange, there is no market to make a sale.

Furthermore, you don’t receive stock options all at once. Instead, you receive shares/options as you meet certain criteria. The stocks that have met the criteria are considered “vested,” which means you can act on them. The vesting schedule lays out when things will happen. In some cases, you receive a certain number of shares each quarter for each year. An example of this would be if you receive 20,000 shares over five years, 5,000 shares would vest in the first year, and another 5,000 would vest each year over the next four years.

Now, we can talk about types of stock options. A very popular option is a non-qualified stock option (NSO). Companies like them because they provide a flexible and efficient way to attract, retain and motivate employees as well as other service providers such as directors and consultants. Workers like them because they represent an opportunity to create wealth, with tax consequences deferred until the end of the year of exercise. That’s the good news.

The bad news is the taxation of NSOs. Ordinary income tax is recognized upon exercise of an NSO based on any excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. In English, this means “if they are in the money.” Also, NSO exercises by employees are subject to tax withholding.

Now, onto incentive stock options (ISOs). ISOs can only be granted to employees and not to consultants and directors. You have to report income when you exercise a non-qualified option (NSO), but not when you exercise an ISO. Further, if shares acquired upon exercise of an ISO are held for more than one year after the date of exercise and more than two years after the date of grant of the ISO, any gain or loss on sale or other disposition will be long-term capital gain or loss.

This is huge when you consider that ordinary income is taxed between 10 percent and 39.6 percent, while long-term capital gains are between 0 and 20 percent.

OK, now that you have an idea of how the rules are applied in this game, let’s look at the strategies.

Most people remember what happened in 2008. The stock market dropped 40 percent in one month. However, the stock market dropped 40 percent during the tech bubble that burst in the early 2000s. So, in the last decade of the last century we have what is now called the “lost decade,” which is the only time the stock market lost money in a 10-year period since the Great Depression.

Is the stock market risky? Yes it is. So why would you expose your stock options to these kinds of gyrations? This is why, in most cases, it makes sense to exercise your options as soon as they become available. In some cases, if you are convinced that the shares in your company will remain stable for one year, it might make sense to hold off on the sale and convert ordinary income to long-term capital gains as outlined above.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual.