Employers can get creative with compensation, especially if aiming to maintain company loyalty with their most valued employees. With roughly one out of every five millennials changing jobs annually, Generation Z is seemingly even more disconnected from their workplace, and the recent Great Resignation, it’s clear how difficult it is to retain talent. Employee stock options represent a carrot-and-stick compensation model many employers use to fight against these recent trends.
Essentially long calls, employee stock options provide the right to buy company stock at a fixed price. For example, assume an employee at Disney (ticker: DIS) is paid stock options to purchase 1,000 shares of DIS stock at $120 in four years while the stock currently trades near $90 per share. The options provide no intrinsic value at the current market price, but where will the stock be in four years? If DIS stock price rises to $150 by then, the employee obtains $30 of intrinsic value per share, resulting in $30,000 of compensation at exercise ($30 intrinsic value x 1,000 shares)! The more stock options provided and the higher the intrinsic value, the more the employee makes.
The four-year period described above is known as the vesting period. This is where the “carrot-and-stick” model comes into play. If an employee is granted stock options with a four-year vesting period, they will forfeit at least some options if they resign before reaching the vesting period. However, many stock options offer “vesting cliffs,” giving employees access to stock options after specific periods (e.g., 250 options vesting yearly).
Two primary types of employee stock options exist; both are similar in structure and share the generalities discussed above. However, it’s essential to keep track of the subtle differences related to taxation for test purposes. The two types are:
Of the two types of employee stock options, non-qualified stock options (NSOs) are less tax beneficial. However, there is no tax consequence when receiving either type of employee stock option. After all, what if the options become worthless once reaching the vesting period?
Let’s revisit the example above to purchase DIS stock at $120, assuming a four-year vesting period with a ten-year term. This means the employee can exercise all their options after four years, but they will expire if they go unexercised ten years after the grant. What if DIS stock never rises above $120 through the 10-year term? Unfortunately, the employee’s options would be worthless. This is why the IRS does not assess a tax on employee stock options when they’re granted.
NSOs are taxed when they’re exercised, which only occurs if any intrinsic value exists. Again, we’ll continue discussing the DIS stock options to purchase 1,000 shares at $120. After the four-year vesting period is reached, assume DIS stock is trading at $180. The employee has access to $60 of intrinsic value!
Upon exercise of the NSOs, the employee is automatically assessed ordinary income tax on the intrinsic value (sometimes referred to as the “bargain element” or “compensation element”). In this example, an additional $60,000 ($60 intrinsic value x 1,000 shares) is added to the employee’s taxable income. To reduce the burden during tax filing the following year, many employers withhold taxes at the time of exercise. Otherwise, the employee is required to pay out of pocket later. Assuming the employee in our example was in the 32% tax bracket, the $60,000 of “additional compensation” would result in an added $19,200 of federal income taxes. The tax assessed is equal to the investor’s marginal income tax rate. The more income one makes, the higher the tax bracket. As of the tax year 2023, these are the income tax brackets for individuals and those filing jointly:
| Rate | Individuals | Married filing jointly |
|---|---|---|
| 10% | $0 | $0 |
| 12% | $11,001 | $22,001 |
| 22% | $44,726 | $89,451 |
| 24% | $95,376 | $190,751 |
| 32% | $182,101 | $364,201 |
| 35% | $231,251 | $462,501 |
| 37% | $578,126 | $693,751 |
Do not memorize these tax brackets; this chart is only for context.
The cost basis of the shares is established once the options are exercised. Equal to the exercise price ($120 per share) plus the intrinsic value ($60 per share), our example’s $180 cost basis now serves as the foundation for a potential capital gain or loss in the future.
We will go into further detail on capital gains taxes in a future chapter, but these are taxes assessed once a security is liquidated. If an investor sells a security at a loss (at a lower price than its cost basis), the amount of the loss is deductible and reduces taxes. If an investor sells a security at a gain (at a higher price than its cost basis), the amount of the gain is taxable. There are two types of capital gains taxes:
Short-term capital gains are obtained when an investor sells a security at a profit after one year or less of ownership. This type of gain is taxed at the same bracket as ordinary income, which could be up to 37%. An employee that exercises NSOs can potentially be subject to a tax rate of up to 37% twice. For example:
An employee of a large corporation is granted non-qualified stock options to purchase 500 shares of company stock at $50 after a vesting period of five years. At the end of the vesting period, the company stock is trading at $80, and the employee exercises the stock options. They hold the shares for nine months, then liquidate them in the market when the stock price is $100.
In this scenario, the employee encounters two tax events. Can you identify them?
The first tax event occurs when the NSOs are exercised. The stock options allow a stock purchase at $50 when the market price is $80, resulting in $30 of intrinsic value per share. Therefore, the first tax event is the additional compensation of $15,000 ($30 intrinsic value x 500 shares), subject to ordinary income tax rates (up to 37%).
The second tax event occurs when those shares are liquidated in the market nine months later. With an initial cost basis per share of $80 and sales proceeds per share of $100, the investor locks in a $20 capital gain per share. The capital gain is short-term as the shares were held for one year or less. The second tax event is the total short-term capital gain of $10,000 ($20 capital gain x 500 shares), also subject to ordinary income taxes (again, up to 37%).
The employee faces $25,000 of taxable ordinary income ($15,000 + $10,000), subject to a tax rate of up to 37%.
Long-term capital gains are obtained when an investor sells a security at a profit after more than one year of ownership. This type of capital gain is typically taxed at 15% or 20%, with taxpayers only at the highest brackets (35% or 37%) paying 20%. Due to the significant decline in tax burden for long-term capital gains (max of 20% vs 37%), investors tend to favor holding securities for more than one year.
An employee of a large corporation is granted non-qualified stock options to purchase 800 shares of company stock at $120 after a vesting period of two years. At the end of the vesting period, the company stock is trading at $160, and the employee exercises the stock options. They hold the shares for 16 months, then liquidate them when the stock price is $190.
Again, the employee encounters two tax events. Can you identify them?
The first tax event occurs when the NSOs are exercised. The options allow a stock purchase at $120 when the market price is $160, resulting in $40 of intrinsic value per share. Therefore, the first tax event is the additional compensation of $32,000 ($40 intrinsic value x 800 shares), subject to ordinary income tax rates (up to 37%).
The second tax event occurs when those shares are liquidated in the market 16 months later. With an initial cost basis per share of $160 and sales proceeds of $190, the investor locks in a $30 capital gain per share. The capital gain is long-term, as the shares were held for over a year. The second tax event is the total long-term capital gain of $24,000 ($30 capital gain x 800 shares), subject to long-term capital gain tax rates (15% or 20%).
The employee faces $32,000 of taxable ordinary income, subject to a tax rate of up to 37%, plus $24,000 of taxable long-term capital gains, subject to a tax rate of 15% or 20%.
Non-qualified stock options may be granted to any person providing services to the company, including contractors, consultants, and other non-employees. This gives the company a way to compensate anyone without paying cash.
Incentive stock options (ISOs) are similar in structure to non-qualified stock options, with two primary differences. First, ISOs may only be granted to company employees, disallowing grants to contractors, consultants, and other non-employee service providers. Second, ISOs are taxed differently than NSOs, sometimes at lower rates.
Like NSOs, ISOs are not subject to taxation upon being granted. Unlike NSOs, they are not taxed at exercise. This is the first tax benefit over NSOs. Even if a significant amount of intrinsic value exists at exercise, it is not taxable.
ISOs don’t avoid taxation - the taxes are just delayed. The holding period of the stock is what determines tax consequences. An employee only pays long-term capital gains tax rates (maximum of 15% or 20%) if the shares are liquidated post-exercise:
*The shares must be held for at least one year and one day to qualify. Holding the shares for exactly one year post-exercise does not qualify for preferential tax treatment.
Otherwise, any gain from the sale of the shares in the market is subject to ordinary income tax rates (up to 37%).
Let’s go through a few examples to understand ISO taxation better.
An officer of a large corporation is granted incentive stock options to purchase 2,000 shares of company stock at $30 on January 25th, 2018. The options have a four-year vesting period and a 10-year term. On February 15th, 2022, the officer exercised the stock options while the company stock was trading at $45. On March 1st, 2023, the officer liquidated the shares in the market at $55.
Can you determine the tax consequences the officer will face?
Answer = $50,000 taxed at long-term capital gains rates (15% or 20%)
For ISOs to be subject to preferential long-term capital gain tax rates (15% or 20%), the officer must meet both of these requirements:
The options were granted on January 25th, 2018, more than five years from the March 1st, 2023 liquidation date. The options were exercised on February 15th, 2022, more than one year from the March 1st, 2023 liquidation date. Both requirements were met, so the investor obtained preferential long-term capital gain tax rate status.
To determine the amount of taxable gains, we must compare the original exercise price ($30 per share) to the eventual liquidation price ($55 per share). The market price upon exercise ($45 per share) is unimportant as ISOs are not subject to taxes at exercise. The officer obtains $25 of total value per share ($30 vs. $55), resulting in $50,000 (2,000 shares x $25) of taxable long-term capital gains.
Let’s try one more:
A director of a mid-sized corporation is granted incentive stock options to purchase 200 shares of company stock at $250 on September 10th, 2017. The options have a five-year vesting period and a ten-year term. On October 12th, 2022, the officer exercised the stock options while the company stock was trading at $300. On August 30th, 2023, the officer liquidated the shares in the market at $325.
Can you determine the tax consequences the officer will face?
Answer = $15,000 taxable at ordinary income rates (up to 37%)
For ISOs to be subject to preferential long-term capital gain tax rates (15% or 20%), the officer must meet both of these requirements:
The options were granted on September 10th, 2017, nearly six years from the August 30th, 2023 liquidation date. The options were exercised on October 12th, 2022, less than one year from the August 30th, 2023 liquidation date. Only one of the requirements was met, so the investor does not obtain preferential long-term capital gain tax rate status. The total benefit of the options is taxed at ordinary income rates (up to 37%).
To determine the amount of taxable ordinary income, we must compare the original exercise price ($250 per share) to the eventual liquidation price ($325 per share). The market price upon exercise ($300 per share) is unimportant as ISOs are not subject to taxes at exercise. The officer obtains $75 of total value per share ($250 vs. $325), resulting in $15,000 (200 shares x $75) of taxable ordinary income.
Sign up for free to take 6 quiz questions on this topic