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Understanding Incentive & Non-Qualified Stock Options

Understanding Incentive & Non-Qualified Stock Options

December 13, 2022
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Employers commonly offer stock options to employees as a way of fostering a greater sense of ownership and encouraging long-term commitment. Those stock options allow for the potential of a higher financial reward than just a salary, especially if the company is successful in growing rapidly. 

Yet with that opportunity for higher growth potential on your stock options comes an added layer of complication both in terms of using them properly and planning for taxes. For instance, what type of stock options do you have? What are the different types of tax treatment for each option? What issues should you be aware of before implementing your stock options strategy?  

To best understand those issues and more, here are five essential things to know about stock options.

Basics of Stock Options

A stock option is a contract that gives its holder the right to purchase stock at a given price (the “strike price” or the “exercise price”) within a set period of time but without any obligation to do so. The holder of an option is said to “exercise” the option by purchasing stock within the time frame allowed, regardless of the market value at the time of exercise. 

Thus, if the market price rises, the holder of an option can purchase stock at the predetermined exercise price, then turn right around and sell the stock for an immediate profit. All options come with an expiration date.

Vesting

An employee usually cannot exercise an option until it “vests,” which means that you fully own the option. Vesting occurs on a predetermined schedule, usually after a fixed amount of time, but vesting can also be based on performance milestones. Some employers may offer gradual vesting schedules, and other options vest on “cliff” schedules (where most or all of the options vest at one time). 

An employer may offer an early exercise provision, allowing options to be exercised before they vest. In the event of early vesting, shares of stock will typically follow the same vesting schedule as the original option contract; if the employee leaves the company before the shares vest, the contract may give the company the right to buy back the shares. The particulars all depend on the terms of the option contract.

Bargain Element

The “bargain element” is the difference between the market price at the time of exercise and the grant price of the option. For instance, let’s say an employee is granted the option to purchase up to 1,000 shares of stock at $20 per share, the market price increases to $50 per share, and the employee exercises the full option. 

The employee pays $20,000 cash and receives shares of stock valued at $50,000. The bargain element is the $30,000 profit that the employee will have realized on the transaction. A stock can be sold at any time, even immediately upon exercise of the option, but in order for the sale profits to qualify as capital gains rather than ordinary income, the shareholder must hold the shares for at least one year.

Clawbacks

A “clawback” provision gives a company the right to reclaim an option or to buy back shares of stock if certain triggering events occur. Common reasons for clawbacks include financial insolvency of the company or termination of employment. An employment contract can potentially allow for clawbacks even after an option is vested.

Non-Qualified Stock Options (NSOs)

There are two types of stock options, and we’ll cover NSOs first. NSOs provide a simple way for employers to incentivize loyalty, but they do not offer the same tax advantages of an ISO. Upon exercise of NSOs, the employee pays ordinary income tax on the difference between the exercise price and the market price (the bargain element). 

Since ordinary income is taxed at a higher rate than long-term capital gains, this can make NSOs less attractive for individuals with higher income levels, but the simplicity of NSOs allows employers to offer this type of option more broadly.

Incentive Stock Options (ISOs)

ISOs are the more complicated type of option, more commonly offered to senior management. ISOs can sometimes offer tax advantages over other types of stock options, but with some restrictions. When an employee exercises an ISO, the profits can qualify as capital gains under two conditions: the employee cannot sell the stock until one year after exercising the option and two years after the grant date

Additionally, the sale of stock purchased from an ISO exercise can potentially incur liability for alternative minimum tax for employees with higher compensation levels; you will need to consult your tax professional to determine if this applies in your case.

Making Sense of Your Stock Options

If you have stock options, they should be considered key components of your financial toolbox. Yet those options inherently carry risk, and stock options might be more volatile than a well-diversified investment portfolio. 

While there is no one-size-fits-all answer as to how to handle your stock options, you should still put a plan in place to determine what’s the best strategy for you. If you’d like to discuss how your stock options can help you achieve your financial goals, we’d love to help. 

You can schedule an appointment here or call me at (949) 631-3840 x2 or email jbang@cfiemail.comfor a no obligation, complementary meeting.

About Jim Peters

Jim Peters is an independent financial advisor and the founder of Grace Wealth Management Group, Inc., a full-service financial firm committed to helping people pursue their financial goals. With more than 24 years of experience in the industry, Jim combines his extensive knowledge with his genuine interest in helping people pursue financial independence. Beyond his experience, he is certified as both a Chartered Life Underwriter® (CLU®) and Chartered Financial Consultant® (ChFC®) professional, meaning he has advanced training and knowledge in financial planning and insurance. Based in Irvine, California, Jim specializes in working with individuals, families, and businesses throughout Orange County. To learn more, connect with Jim on LinkedIn or visit www.financialadvisorirvine.com.