Not only employee-owned companies work with stock options

Do you have stock options from your employer? Make sure you know the rules before exercising them, or you may be in for some unpleasant surprises.
Even though the boom days of the 1990s have passed, employee stock option programs continue to be popular with both public and private companies.  As long as they take steps to learn the basic rules, employees stand to profit handsomely from these valuable benefits.
In the dot-com “go-go” days of the 1990s and early 2000s, many companies frequently used employee stock option plans as a way to reward and retain valued staff.  Everyone from top level executives to temporary administrative help participated in some companies. Although the modern Great Recession has produced fewer “company stock millionaires” these days, stock option programs are still popular with public and private companies.

What Is a Stock Option?

If your company benefits package includes stock options, you’ve been given the right to purchase shares of your company’s stock at a specific price and under certain conditions set by company management.
Vested options allow you to purchase a specific number of shares only after you’ve satisfied a time-in-service commitment for your employer.
If your options are performance-based, these will vest once you or your company meet specified goals.
If you have immediate options, you can purchase your allotted shares whenever you like.

The two most common types of employee stock option plans are incentive stock option (ISO) and nonqualified stock option (NSO) plans. Typically, ISOs are reserved for key executives, while staff on lower rungs of the corporate ladder may be issued NSOs. The primary difference between the two option types is how they are treated for tax purposes.

An ISO may be taxed as a long-term capital gain, assuming the employee holds the stock for at least two years from the option grant date and one more year from the exercise date. They are also taxed only when the stock is sold, effectively creating a  tax-deferred investment plan. However, ISOs may trigger alternative minimum tax (AMT) liability. Be sure to discuss this with your tax advisor to see exactly how your taxes may be affected.
NSOs are not quite as attractive, since they are taxed as both income and capital gains.  Income tax is owed once the options are exercised (when you purchase the stock). This is an important consideration to anyone who is thinking of exercising options. If you don’t have enough cash available, you may need to sell some of the shares you’ve just purchased in order to pay the tax bill.

Exercising Options

Stock options often have an exercise period of 10 years.  This means you have 10 years from the time your company grants you the options to actually purchase the stock. You are not obligated to buy any shares, particularly if your company’s stock price is trading below the option exercise price. If you choose not to purchase the stock during the exercise period, your options will expire worthless.

Some companies may offer the flexibility to exchange option grants if the market price of their stock has dropped significantly. For example, if your stock options have an exercise price of $50 a share and your company stock has been trading at only $40 a share for a long time, the company may exchange your $50 strike price options for a new set of options with a lower strike price.

If you are participating in an employee stock option plan, consult with a financial and/or tax professional who can help you decide when to exercise your shares and how to deal with the tax consequences.