Stock options can also be confusing, which leaves you vulnerable to making mistakes. You should take the time to understand the terms of your ESOs. They can be a significant part of your compensation package, but you must know the ins and outs to take full advantage. Taxes can have a huge impact on your choices.
Employee stock option plans
The tax treatment of your ESO depends on the type. With an ISO, you get a tax advantage upfront. Instead of reporting the stock option as income when you exercise it, you wait until you sell the stock to pay income tax. With an NSO, you pay the tax when you exercise your option. An NSO also requires you to report any long-term capital gains when you sell the stock. One potential hazard of ESOs is if you make the mistake of putting all your eggs in one basket. If you concentrate your investment portfolio with company shares, you could suffer a significant loss if the stock price of your company crashes.
Additionally, since most options have a vesting schedule, make sure you know what happens if you leave the company.
What are the different types of stock options?
If you leave your employer, you may still have three months to exercise your right to buy vested stock options. Any publicly traded company can choose to offer stock options to its employees. In some cases, private companies may also offer ESOs. Stock option plans are a popular benefit that companies can offer employees. Tech companies and startups are common types of businesses that have ESOs, a trend that picked up speed in the s. Some top companies provide the option to buy stock as part of their compensation package.
Not all stocks are bought and sold in the open market through an exchange. It includes stocks, debt securities, and derivatives.
About Stock Options
Derivatives base their value on the value of something else. Without public stock, marketing the shares is difficult. If a company issued ESOs with OTC stock, it would be run by a group of dealers on a decentralized network connected by telephones and computers to manage trades. Employee stock options ESOs and stock option grants are similar. Companies can use both to reward employees or as part of overall compensation or salary.
Despite their similarities, significant differences exist between the two. If your employer gives you ESOs, you have the option to purchase shares of the company stock. Usually, the contract puts a limit on the number of stocks you can buy. The contract also sets the stock price ahead of time and includes an expiration date when the ESO expires. While ESOs can let you exercise your purchase right away or require you to be vested, stock grants — which give you stock, not just the option to buy stock — almost always require you to be vested before receiving shares.
Stock options are helpful in recruiting new talent to a company. Any restrictions that are placed upon the exercise or sale of the stock by the company can also delay taxation in many cases until the restrictions have been lifted, such as when the employee satisfies the vesting schedule in the plan. These plans can also be labeled as qualified or non-qualified, although these terms should not be confused with retirement plans that are labeled as qualified or non-qualified, where the former type of plan is subject to ERISA guidelines while the latter is not.
In general, qualified stock option plans do not immediately tax the employee upon the difference between the exercise and market price of the stock being purchased, while non-qualified plans do. Stock options mean additional compensation in the form of discounted stock purchases, which can be redeemed either now or later at an instant profit.
In many cases, the options themselves come to have tangible value, particularly if the employee is able to exercise the option at a price far below where it is currently trading. Workers can also benefit from knowing that their efforts are at least indirectly contributing to the rise in the value of their investment. Employers reward their employees with stock for two main reasons. The first is that it is cheaper and easier for the company to simply issue shares of stock rather than pay cash to employees.
The second is that this form of compensation can serve to increase employee motivation; a workforce that owns a piece of its employer gets to share directly in the profits of the company at large in addition to receiving their weekly paychecks. This can improve employee morale and loyalty, and reduce turnover in the workforce — as well as create another group of investors buying company shares. Those who have accumulated substantial amounts of stock or options can see their net worths decline sharply in very short periods of time in some cases, such as during severe market downturns and corporate upheaval.
When company stock loses value, it can leave employees feeling discouraged and lead to reduced productivity and morale. This is the simpler of the two forms of employee stock compensation that come in the form of an option. These options are also referred to as non-qualified stock options due to their tax treatment, which is not as favorable as that accorded to their statutory cousins.
Non-statutory options usually require employees to immediately recognize the difference between the exercise price and the market price of the stock option upon exercise. This amount will be reported as a short-term taxable gain.
Non-statutory stock options are offered primarily to rank-and-file employees of corporations as a means of achieving a share of ownership in the company. Also known as incentive or qualified stock options, statutory stock options are typically only offered to key employees and corporate executives as a special type of compensation. Statutory stock options can be exercised and sold on a more tax-advantaged basis than non-statutory shares because no income is recognized by the exercise of these options.
Income is never recognized with these options, in fact, until the stock is actually sold. However, the income from these options can sometimes trigger the Alternative Minimum Tax. Many corporate executives and insiders who are awarded company stock are only allowed to sell the stock under certain conditions in order to comply with regulations aimed at curbing insider trading , such as requiring the executive to wait for a certain period of time before selling. This is known as restricted stock. RSUs, on the other hand, are a device to grant shares of stock or their cash value at a future date according to a vesting schedule without conveying actual shares or cash until the vesting requirement is satisfied.
This is perhaps the simplest type of employee stock purchase program. ESPPs are funded via payroll deduction on an after-tax basis. These plans can be qualified, which allows for long-term capital gains treatment under certain conditions, or non-qualified, depending on plan type and how long the stock is held before it is sold. This is a type of qualified plan that is funded entirely with company stock. ESOPs are often used by closely held businesses as a means of providing a liquid market for the company stock on a tax-advantaged basis; owners can place their shares of the company inside the plan and then sell these shares back to the company at retirement.
These are perhaps the best plans available from a tax perspective because income from the sale stock is never recognized until it is distributed at retirement, just as with any other type of qualified plan. This form of retirement plan funding came under close scrutiny by regulators after the Enron and Worldcom meltdown in Although many employers still dole out company shares to employees in their retirement plans, employees need to ensure that they are adequately diversified in their retirement portfolios according to their risk tolerances and investment objectives.
The employees at Enron and Worldcom can bitterly attest to the foolishness of putting their entire retirement portfolios in a single company. Phantom stock is named as such because there may be no real shares of stock issued or transferred. This type of stock is typically geared to benefit executives and key employees, who may be required to meet certain requirements in order to be eligible for the plan.
Employees receive many of the financial benefits of stock ownership without actually owning the stock. That said, neither option should be considered too complex to issue if its benefits outweigh the costs.
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Depending on your needs, the cost of creating a stock option plan can vary significantly. In order to get a better sense of cost for your particular situation, put in a request to schedule a complimentary consultation and free price quote from one of our lawyers. Unfortunately, there is no clear answer to this. Both have their advantages and disadvantages.
The answer will really depend on who you want to offer stock options and the limitations and returns you want from offering this benefit. Talk to a startup lawyer about your unique situation to get a better idea of what each could offer. Toggle Navigation. What Are NQOs?