How to avoid taxes when exercising stock options

Avoid Premature Exercise On Employee Stock Options.

The first rule of managing your employee stock options is to avoid premature exercises. Why? Because it forfeits the remaining "time premium" back to your employer and incurs an early compensation income tax to you, the employee.

When employee stock options are granted, the entire value consists of "time premium" because there generally is no intrinsic value at the grant date since the exercise price is generally the market price on the day of the grant.

This time premium is a real value and not an illusion. The time premium is what the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) require all the companies to value at the grant date and expense against their earnings over the option's vesting period. The maximum contractual time to expiration is 10 years but evaluators use what is called the expected time to expiration as an input assumption into theoretical pricing models such as the Black Scholes model.

When a grantee receives an employee stock options grant, he receives a value and the employer takes on a contractual liability to perform in respect of the grantee's contract. The value of the company's liability should be equal to the value of the benefit to the employee. Some pundits speculate that the cost to the employer is greater than the real and perceived benefit to the employee/grantee. This may be the case when options are misunderstood by the employee/grantee. But in most cases, the values that companies expense are actually understated, with the value to informed grantees being greater than the assumed liability costs to the company. (For more insight, read our Employee Stock Option Tutorial .)

If the stock moves up and is in-the-money, then there is now an intrinsic value. But, there is also still a time premium; it doesn't just disappear. Often the time premium is greater than the intrinsic value, especially with highly volatile stocks, even if there is substantial intrinsic value.

When a grantee exercises ESOs prior to expiration day, he gets penalized in two ways. First, he forfeits all of the remaining time premium, which essentially goes to the company. He then receives only the intrinsic value minus a compensation, tax which includes state and federal tax and Social Security charges. This total tax may be more than 50% in places like California, where many of the options grants take place. (These plans can be lucrative for employees - if they know how to avoid unnecessary taxes. Check out Get The Most Out Of Employee Stock Options .)

The graph above illustrates how the money is divided up upon early exercise of the employee stock options.

Assume for a moment that the exercise price is 20, the stock is trading at 40, and there are 4.5 years of expected life to expiration. Assume also that the volatility is .60 and the interest rate is 3% with the company paying no dividend. The time premium would be $6,460. (Had the assumed volatility been lower, the amount forfeited would be lower.) The $6,460 would be forfeited back to the company in the form of a reduced liability to the grantee.

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Options advisors or wealth managers often advocate forfeiting the time premium and paying the tax by premature exercises in order to use the money to diversify (as if a diversified portfolio is some sort of magic bullet). They essentially advocate that you return a large part of your compensation to the employer and pay an early tax for the privilege of diversifying into some mutual fund loaded with fees and commissions, which underperforms the indexes. Some claim that the reason advisors advise and the companies endorse the idea of making early exercises is because it is highly beneficial to the company in the form of early tax credits and reduced liabilities. That could certainly be the reason that early exercises are the predominant method that employees use to manage their options.

It is a mystery to me why there is no litigation from employees and executives who are recipients of this premature exercise and diversify advice; had an employee made premature exercises prior to the recession of 2008, diversified his portfolio and bought mutual funds, he would now have a value of less than 35% of the theoretical value of the options when he exercised.

Stay away from premature exercises and hedge your positions by selling calls and buying puts. You will end up with a lot more money if you do. (Learn the different accounting and valuation treatments of ESOs, and discover the best ways to incorporate these techniques into your analysis of a stock in Accounting and Valuing Employee Stock Options .)

Three Ways To Avoid Tax Problems When You Exercise Options.

I love the movie Wall Street because Gordon Gekko’s single-minded pursuit of money led to his downfall. This is not just a Hollywood story. In my past role as a tax accountant in Silicon Valley, I saw many executives and employees get greedy, too. By attempting to capture an early gain in their company’s stock, they exercised so many stock options that they didn’t have enough money to pay the taxes due on their gains.

A surprisingly large number of people fall into this trap. Some of them are just ill-informed. Others, I believe, are overcome by their greed: It causes them to forget that stock prices can go down as well as up, or keeps them from embracing a rational plan to pay the taxes.

Up A Creek.

In most cases, when you exercise your options, income taxes will be due on the excess of the option value (set either by the company’s board of directors, if it is private, or by the market, if it is public) over its exercise price.

If you have non-qualified options (“Non quals” or NQOs), your employer must withhold taxes when you exercise your options, as if you had received a cash bonus. The employer decides how much to withhold, based on guidelines from the IRS and the states. Unless you sell stock at the time of exercise to cover your withholding, you will have to write a check to your employer for the taxes withheld.

If you have incentive stock options (ISOs), your employer will not withhold taxes. That means it’s up to you to self-regulate and set aside the taxes you’ll owe.

Whether you have NQOs or ISOs, you will need to set aside money held in another account, like a savings or money market account, to pay taxes.

Whether you have NQOs or ISOs, you will need to set aside money held in another account, like a savings or money market account, to pay taxes. If you don’t have the resources to pay the tax due on an option exercise, you should consider exercising fewer options so you don’t create an income tax obligation you can’t afford to pay.

Following are two scenarios that show what can happen if you get greedy and exercise as many options (either non-quals or ISOs) as you can without a plan. You might find yourself in a financial quagmire, stuck owing more in taxes than you have cash on hand to pay.

NQO SCENARIO.

You exercise a non-qualified stock option when its value is $110 and your exercise price is $10.

Your taxable compensation income is $100.

Assume you are in the highest federal and state income tax brackets, so you owe 50% of the gain to the government.

Your tax on the exercise is $50. You’ll write a check to your employer for the $35 of federal and state taxes the company must withhold. You still owe $15 in taxes.

At this point you own stock in your employer, you’ve paid $10 to exercise options, and $35 for tax withholding.

What happens next?

The stock price drops to $10, at which time you sell your stock.

The final result is you have no stock, have spent $35 for taxes and still owe $15 in taxes (the $10 to exercise NQO and $10 from stock sale net to zero).

Put enough zeros behind these numbers, and you can see how this becomes a problem.

Yes, the $100 loss on the stock sale is tax deductible, but it is a capital loss. The loss deduction may be subject to annual limits, so your tax savings may not be realized for many years.

ISO SCENARIO.

You exercise an ISO when its value is $110 and your exercise price is $10.

You have no taxable income for regular tax purposes and $100 taxable income for Alternative Minimum Tax (AMT) purposes. The exercise of the ISO will likely cause you to be subject to AMT for federal purposes and may cause you to be subject to the AMT for state purposes, so assume you owe 35% of the gain to the government.

Therefore your tax on the exercise is $35, and since employers don’t withhold taxes on ISO exercises you must be prepared to pay this $35 from your own resources.

At this point you own stock in your employer, you’ve paid $10 to exercise options, and have a $35 tax obligation.

What happens next?

The stock price drops to $10, at which time you sell your stock.

The final result is you have no stock, but you still owe $35 in taxes (the $10 to exercise ISOs and $10 from stock sale net to zero).

It was in the cases of ISOs[1] that I more often saw people in IRS nightmares, with tax bills in the hundreds of thousands or even millions they couldn’t pay.

As in the case of non-qual exercises, the $100 loss is tax deductible, but may be subject to annual limits. Also note that you will have a different basis in your stock for regular tax and AMT purposes, as well as an AMT credit carryover, which should be taken into consideration.

Do these scenarios sound unlikely? I have seen versions of them happen dozens of times, often enough that I tell this cautionary tale whenever I can.

What can be done to avoid a potential problem?

• If your employer is public, consider selling at least enough stock at exercise to pay for your ultimate tax liability. This is commonly referred to as a cashless exercise. On exercise, you immediately sell enough stock to pay both the exercise price and your anticipated tax liability. (But remember that you should still set aside some money for the incremental tax due).

If you don’t have enough to pay the taxes, consider exercising fewer options.

• Exercise fewer options so that you keep money aside to pay taxes. This is the hardest choice for many people to make, because they worry that if they don’t act now, that they will have missed a potential big opportunity.

• Consider exercising your options in a staggered fashion. If you hold stock from previously exercised options, that gives you the opportunity to sell the stock as you exercise additional options. This choice can be particularly beneficial if stock has been held for over one year and the associated gain qualifies for favorable long-term capital gain tax treatment.

Manage Your Downside Risk.

Be just as rational when it comes to your options as you are when you are planning your investment portfolio. Stock values don’t always increase over time. Part of what you’re doing is managing downside risks. That may mean parting with some of the potential upside to avoid a catastrophic downside.

Being greedy, or unprepared, and betting all of your assets on the future of your employer’s stock can produce some unexpected and undesirable financial consequences.

This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction.

About the author.

Bob Guenley was a tax accountant to Silicon Valley executives from the 1980s through the 2000s, and currently works for a leading venture capital firm.

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Get The Most Out Of Employee Stock Options.

An employee stock option plan can be a lucrative investment instrument if properly managed. For this reason, these plans have long served as a successful tool to attract top executives. In recent years, they've become a popular means to lure non-executive employees.

Unfortunately, some still fail to take full advantage of the money generated by their employee stock. Understanding the nature of stock options, taxation and the impact on personal income is key to maximizing such a potentially lucrative perk.

What's an Employee Stock Option?

An employee stock option is a contract issued by an employer to an employee to buy a set amount of shares of company stock at a fixed price for a limited period of time. There are two broad classifications of stock options issued: non-qualified stock options (NSO) and incentive stock options (ISO).

Non-qualified stock options differ from incentive stock options in two ways . First, NSOs are offered to non-executive employees and outside directors or consultants. By contrast, ISOs are strictly reserved for employees (more specifically, executives) of the company. Secondly, nonqualified options do not receive special federal tax treatment, while incentive stock options are given favorable tax treatment because they meet specific statutory rules described by the Internal Revenue Code (more on this favorable tax treatment is provided below).

NSO and ISO plans share a common trait: they can feel complex. Transactions within these plans must follow specific terms set forth by the employer agreement and the Internal Revenue Code.

Grant Date, Expiration, Vesting and Exercise.

To begin, employees are typically not granted full ownership of the options on the initiation date of the contract, also know as the grant date. They must comply with a specific schedule known as the vesting schedule when exercising their options. The vesting schedule begins on the day the options are granted and lists the dates that an employee is able to exercise a specific number of shares.

For example, an employer may grant 1,000 shares on the grant date, but a year from that date, 200 shares will vest, which means the employee is given the right to exercise 200 of the 1,000 shares initially granted. The year after, another 200 shares are vested, and so on. The vesting schedule is followed by an expiration date. On this date, the employer no longer reserves the right for its employee to purchase company stock under the terms of the agreement.

An employee stock option is granted at a specific price, known as the exercise price. It is the price per share that an employee must pay to exercise his or her options. The exercise price is important because it is used to determine the gain, also called the bargain element, and the tax payable on the contract. The bargain element is calculated by subtracting the exercise price from the market price of the company stock on the date the option is exercised.

Taxing Employee Stock Options.

The Internal Revenue Code also has a set of rules that an owner must obey to avoid paying hefty taxes on his or her contracts. The taxation of stock option contracts depends on the type of option owned.

For non-qualified stock options (NSO):

The grant is not a taxable event. Taxation begins at the time of exercise. The bargain element of a non-qualified stock option is considered "compensation" and is taxed at ordinary income tax rates. For example, if an employee is granted 100 shares of Stock A at an exercise price of $25, the market value of the stock at the time of exercise is $50. The bargain element on the contract is ($50 to $25) x 100 = $2,500. Note that we are assuming that these shares are 100 percent vested. The sale of the security triggers another taxable event. If the employee decides to sell the shares immediately (or less than a year from exercise), the transaction will be reported as a short-term capital gain (or loss) and will be subject to tax at ordinary income tax rates. If the employee decides to sell the shares a year after the exercise, the sale will be reported as a long-term capital gain (or loss) and the tax will be reduced.

Incentive stock options (ISO) receive special tax treatment:

The grant is not a taxable transaction. No taxable events are reported at exercise. However, the bargain element of an incentive stock option may trigger alternative minimum tax (AMT). The first taxable event occurs at the sale. If the shares are sold immediately after they are exercised, the bargain element is treated as ordinary income. The gain on the contract will be treated as a long-term capital gain if the following rule is honored: the stocks have to be held for 12 months after exercise and should not be sold until two years after the grant date. For example, suppose that Stock A is granted on January 1, 2007 (100% vested). The executive exercises the options on June 1, 2008. Should he or she wish to report the gain on the contract as a long-term capital gain, the stock cannot be sold before June 1, 2009.

Other Considerations.

Although the timing of a stock option strategy is important, there are other considerations to be made. Another key aspect of stock option planning is the effect that these instruments will have on overall asset allocation. For any investment plan to be successful, the assets have to be properly diversified.

An employee should be wary of concentrated positions on any company's stock. Most financial advisors suggest that company stock should represent 20 percent (at most) of the overall investment plan. While you may feel comfortable investing a larger percentage of your portfolio in your own company, it's simply safer to diversify. Consult a financial and/or tax specialist to determine the best execution plan for your portfolio.

Bottom Line.

Conceptually, options are an attractive payment method. What better way to encourage employees to participate in the growth of a company than by offering them to share in the profits? In practice, however, redemption and taxation of these instruments can be quite complicated. Most employees do not understand the tax effects of owning and exercising their options.

As a result, they can be heavily penalized by Uncle Sam and often miss out on some of the money generated by these contracts. Remember that selling your employee stock immediately after exercise will induce the higher short-term capital gains tax. Waiting until the sale qualifies for the lesser long-term capital gains tax can save you hundreds, or even thousands.

What Is the Tax Rate on Exercising Stock Options?

Understand the complex tax rules that cover employee stock options.

Most workers receive only a salary for their work, but some are fortunate enough to receive stock options as well. Employee stock options can dramatically increase your total compensation from your employer, but they also have tax consequences that can complicate your return. What tax rate you pay when you exercise stock options depends on what kind of options you receive.

Incentive stock options vs. nonqualified stock options.

The reward for incentive stock options is that you don't have to pay any tax on the difference between the exercise price and the fair market value of the stock you receive at the time you exercise the option. In addition, if you hold the stock for a year after you exercise -- and at least two years after the date you received the option -- then any profit is treated as long-term capital gains and taxed at a lower rate.

Why nonqualified stock options aren't as good as incentive stock options.

If the option doesn't meet the requirements of an incentive stock option, then it's taxed as a nonqualified stock option. In that case, you have to pay income tax at your ordinary income tax rate on the difference between the exercise price and the fair market value of the stock you receive at the time you exercise the option. That paper profit is added to your taxable income even if you don't sell the shares you get when exercising the option.

When you later sell your shares, the tax rate you pay depends on how long you hold the shares. If you sell the shares within a year of when you exercised the option, then you'll pay your full ordinary income tax rate on short-term capital gains. If you hold them longer than a year after exercise, then lower long-term capital gains rates will apply.

The key in stock option tax treatment is which of these two categories includes what you got from your employer. Talk with your HR department to make sure you know which one you have so you can handle it correctly.

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