Employers can get creative with compensation, especially when they’re trying to keep their most valued employees. With roughly one out of every five millennials changing jobs annually, Generation Z seemingly even more disconnected from their workplace, and the recent Great Resignation, retaining talent can be difficult. Employee stock options are a common “carrot-and-stick” approach employers use to help address these trends.
Essentially long calls, employee stock options give you the right to buy company stock at a fixed price.
For example, assume an employee at Disney (ticker: DIS) receives stock options to purchase 1,000 shares of DIS at $120 in four years, while the stock currently trades near $90 per share. At today’s market price, the options have no intrinsic value. But the key question is: where will the stock be in four years?
If DIS rises to $150 by then, the employee has $30 of intrinsic value per share. That’s $30,000 of compensation at exercise ($30 intrinsic value × 1,000 shares). The more options granted - and the higher the intrinsic value at exercise - the more the employee can benefit.
The four-year period described above is the vesting period. This is where the “carrot-and-stick” model shows up. If an employee is granted options with a four-year vesting period, they’ll forfeit at least some options if they resign before vesting. Many plans also use vesting cliffs, which release options in chunks after specific time periods (e.g., 250 options vesting each year).
Two primary types of employee stock options exist. They’re similar in structure and follow the general ideas above, but they differ in taxation (which is important for test purposes):
Of the two types, non-qualified stock options (NSOs) are generally less tax-advantaged.
There is no tax consequence when receiving either type of employee stock option. That makes sense: when options are granted, there’s no guarantee they’ll ever be worth anything.
Let’s revisit the DIS example: options to buy 1,000 shares at $120, with a four-year vesting period and a ten-year term. The employee can exercise after four years, but the options expire ten years after the grant if they aren’t exercised.
If DIS never rises above $120 during the 10-year term, the options would be worthless. That’s why the IRS does not tax employee stock options at the time they’re granted.
With NSOs, taxation happens at exercise, but only if the options have intrinsic value.
Continuing the example: after the four-year vesting period, assume DIS is trading at $180. The employee now has $60 of intrinsic value per share.
When NSOs are exercised, the intrinsic value (also called the bargain element or compensation element) is taxed as ordinary income. In this example:
That $60,000 is added to the employee’s taxable income. Many employers withhold taxes at exercise to reduce the employee’s tax bill later. Otherwise, the employee must pay out of pocket when filing.
If the employee is in the 32% marginal bracket, the added $60,000 of ordinary income creates $19,200 of federal income tax ($60,000 × 32%). The tax assessed is based on the investor’s marginal income tax rate: as income rises, the marginal bracket can rise.
As of 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.
Once the options are exercised, the cost basis of the shares is set. It equals:
So the cost basis becomes $180 per share. That cost basis is what you’ll use later to calculate a capital gain or loss when the shares are sold.
We will go into further detail on capital gains taxes in a future chapter, but the key idea is that capital gains taxes apply when a security is liquidated:
There are two types of capital gains taxes:
Short-term capital gains occur when an investor sells a security at a profit after one year or less of ownership. Short-term gains are taxed at the same rates as ordinary income (up to 37%). That means an employee who exercises NSOs can potentially face ordinary income tax rates 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 occur when an investor sells a security at a profit after more than one year of ownership. Long-term gains are typically taxed at 15% or 20%. Generally, only taxpayers in the highest brackets (35% or 37%) pay 20%.
Because long-term capital gains rates are lower than ordinary income rates (max of 20% vs. 37%), investors often prefer 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 service providers without paying cash.
Incentive stock options (ISOs) are similar in structure to NSOs, but they differ in two main ways.
First, ISOs may only be granted to company employees. They can’t be granted to contractors, consultants, or other non-employee service providers.
Second, ISOs are taxed differently than NSOs, and the tax rates can be lower.
Like NSOs, ISOs are not taxed when they’re granted. Unlike NSOs, ISOs are not taxed at exercise. That’s the first tax advantage: even if there’s significant intrinsic value at exercise, it isn’t taxable at that time.
ISOs don’t eliminate taxes - the taxes are delayed. The holding period determines the tax treatment.
An employee pays long-term capital gains tax rates (maximum of 15% or 20%) only if the shares are sold after:
*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 selling the shares is taxed at ordinary income tax rates (up to 37%).
Let’s work through a few examples to make ISO taxation concrete.
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 receive preferential long-term capital gain tax rates (15% or 20%), both requirements must be met:
The options were granted on January 25th, 2018, which is more than five years before the March 1st, 2023 liquidation date. The options were exercised on February 15th, 2022, which is more than one year before the March 1st, 2023 liquidation date. Both requirements were met, so the sale qualifies for long-term capital gain treatment.
To determine the taxable gain, compare the exercise price ($30 per share) to the liquidation price ($55 per share). The market price at exercise ($45 per share) doesn’t matter here because ISOs are not taxed at exercise.
The officer’s gain is $25 per share ($55 − $30), for a total of $50,000 (2,000 × $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 receive preferential long-term capital gain tax rates (15% or 20%), both requirements must be met:
The options were granted on September 10th, 2017, which is nearly six years before the August 30th, 2023 liquidation date. The options were exercised on October 12th, 2022, which is less than one year before the August 30th, 2023 liquidation date. Only one requirement was met, so the sale does not qualify for preferential long-term capital gain treatment. The total benefit is taxed at ordinary income rates (up to 37%).
To determine the taxable ordinary income, compare the exercise price ($250 per share) to the liquidation price ($325 per share). The market price at exercise ($300 per share) is not used because ISOs are not taxed at exercise.
The officer’s total benefit is $75 per share ($325 − $250), for a total of $15,000 (200 × $75) of taxable ordinary income.
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