When you exercise, you can typically do it in one of several ways. First, you can pay cash to purchase the shares.
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One thousand shares have vested since you received your option grant. One risk associated with this approach is that your investment is subject to a possible downturn in the stock price. The third approach is to exercise and sell all your shares immediately , commonly referred to as a same-day sale. While the actual steps for exercising your incentive stock options are relatively simple, the method you choose depends on several factors, including when you need the income from the stock sale, possible tax strategies, and your confidence in the future growth of the company.
A financial professional can advise you on a sound strategy and help you maximize your return based on your situation. Once your incentive stock options have vested, you have the flexibility to choose when to exercise your stock options. All these factors can impact when you decide to exercise your options. There are two definitions associated with exercising incentive stock options, depending on how long you hold your shares before selling them after exercising your options. There is an important exception regarding the timing of exercising incentive stock options. This window typically opens immediately following earnings announcements and closes by mid-quarter.
Within the confines of the trading window, you are free to exercise your vested options at your discretion. Ordinarily, purchasing company stock on the open market requires you to use your funds to acquire the stock.
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If the stock appreciates, your money is working for you. If the stock price declines, your investment is worth less than when you started. Incentive stock options give you the potential to participate in the appreciation of a stock with no capital outlay or financial risk on your part. However, in this scenario, you would need to come up with the initial investment, which would have been subject to potential market volatility, and your funds would have been tied up for five years to accomplish the same profit.
As you can see, incentive stock options can be a powerful way to participate in stock price appreciation without having to put your own money at risk. Tax treatments are an important part of financial planning and a topic that requires careful consideration. One of the advantages of incentive stock options is the tax treatment they receive.
As discussed, there are two approaches to exercising your options — qualifying and disqualifying dispositions. Qualifying dispositions are treated as long-term capital gains. Disqualifying dispositions are treated as ordinary income, with an important difference. There are no payroll taxes associated with the income from a disqualifying disposition, saving you a potentially significant amount of tax dollars. Your earned income is not only subject to standard income tax, but also payroll taxes for Medicare and FICA.
Medicare tax helps provide health insurance to retirees 65 and older, as well as some who are disabled. Medicare is taxed at a rate of 2. Medicare taxes are applied to all earnings, regardless of your income level and an additional 0. In , the Social Security tax rate is 6. Because the profits or income from Incentive stock options are not subject to FICA or Medicare payroll taxes, you can keep a meaningful amount of the profits from your stock exercise. There are times when you need to be able to access the profits from an incentive stock option quickly, perhaps to cover the cost of a down payment on a home, college costs, or other needs.
However, if you have the flexibility to exercise and hold your shares for more than one year before selling them, the sale is considered a qualifying disposition, as discussed above.
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One of the key benefits of qualifying dispositions is the tax treatment they receive. This is attractive because long-term capital gains are typically a lower tax rate than ordinary income or short-term capital gains rates. In addition, many other compensation programs, such as non-qualified stock options, are treated as ordinary income on your W-2, creating a potentially significant tax burden.
Incentive stock options are a type stock option type that may allow you to take advantage of long-term capital gains tax rates, making them an attractive component of your overall compensation. When you exercise your incentive stock options, you may be subject to the alternative minimum tax. In the given tax year, when you exercise your incentive stock options, the difference between the exercise price of the options and the fair market price at exercise is considered income that can trigger an AMT liability. Fortunately, you may be able to take advantage of the AMT credit for the year you sell your incentive stock option shares as a qualifying disposition.
The AMT credit may help to reduce your tax liability. As the company prospers, the stock price often will rise, and the value of your options will increase along with it. This feeling of ownership in the company, and the prospect of increased income, often improves employee retention, morale, and employee satisfaction. Your efforts to help the company succeed are rewarded tangibly through the value of incentive stock options. As we discussed, exercising your incentive stock options may trigger an AMT liability, which can cause a cash flow shortage at tax time.
In the context of compensation, founders, executives, and employees typically gain rights to their grant of equity incrementally over time, subject to restrictions. People may refer to their shares or stock options vesting, or may say that a person is vesting or has fully vested.
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A person vests only while they work for the company. Awards of stock, stock options , and RSUs are almost always subject to a vesting schedule. Similarly, if the company is sold within a year of your arrival, depending on what your paperwork says, you may receive nothing on the sale of the company. A very common vesting schedule is vesting over 4 years , with a 1 year cliff.
Compensation: Incentive Plans: Stock Options
When they work well, cliffs are an effective and reasonably fair system to both employees and companies. But they can be abused and their complexity can lead to misunderstandings:. The intention of a cliff is to make sure new hires are committed to staying with the company for a significant period of time. However, the flip side of vesting with cliffs is that if an employee is leaving—quits or is laid off or fired—just short of their cliff, they may walk away with no stock ownership at all, sometimes through no fault of their own, as in the event of a family emergency or illness.
In situations where companies fire or lay off employees just before a cliff, it can easily lead to hard feelings and even lawsuits especially if the company is doing well enough that the stock is worth a lot of money. As entrepreneur Dan Shapiro explains, this is often for good reason. Your manager may well agree that is is fair for someone who has added a lot of value to the company to own stock even if they leave earlier than expected, especially for something like a family emergency.
These kinds of vesting accelerations are entirely discretionary, however, unless you negotiated for special acceleration in an employment agreement. Such special acceleration rights are typically reserved for executives who negotiate their employment offers heavily. Acceleration when a company is sold called change of control terms is common for founders and not so common for employees.
Companies may impose additional restrictions on stock that is vested. And it can happen that companies reserve the right to repurchase vested shares in certain events. Options are only exercisable for a fixed period of time, until they expire, typically seven to ten years as long as the person is working for the company. But this window is not always open. Options can expire after you quit working for the company. Often, the expiration is 90 days after termination of service, making the options effectively worthless if you cannot exercise before that point.
In fact, you can find out when you are granted the options, or better yet, before you sign an offer letter. Recently since around a few companies are finding ways to keep the exercise window open for years after leaving a company, promoting this practice as fairer to employees. Whether to have extended exercise windows has been debated at significant length. Key considerations include:. Everyone agrees that employees holding stock options with an expiring window often have to make a painful choice if they wish to leave: Pay for a substantial tax bill perhaps five to seven figures on top of the cost to exercise possibly looking for secondary liquidity or a loan or walk away from the options.
On the other side, a few companies and investors stand by the existing system, arguing that it is better to incentivize people not to leave a company, or that long windows effectively transfer wealth from employees who commit long-term to those who leave. It is possible for companies to extend the exercise window by changing the nature of the options converting them from ISOs to NSOs and many companies now choose to do just that.
Another path is to split the difference and give extended windows only to longer-term employees. With the risks of short exercise windows for employees becoming more widely known, longer exercise windows are gradually becoming more prevalent. As an employee or a founder, it is fairer and wiser to understand and negotiate these things up front, and avoid unfortunate surprises. The FAST templates give some typical guidelines about this.
Confusingly, lawyers and the IRS use several names for these two kinds of stock options, including statutory stock options and non-statutory stock options or NSOs , respectively. ISOs are common for employees because they have the possibility of being more favorable from a tax point of view than NSOs. But ISOs have a number of limitations and conditions and can also create difficult tax consequences. The option holder becomes a stockholder sooner, after which the vesting applies to actual stock rather than options.
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This will have tax implications. While stock options are the most common form of equity compensation in smaller private companies , RSUs have become the most common type of equity award for public and large private companies. Facebook pioneered the use of RSUs as a private company to allow it to avoid having to register as a public company earlier.
Each unit represents one share of stock or the cash value of one share of stock that the employee will receive in the future. RSUs are difficult in a startup or early stage company because when the RSUs vest, the value of the shares might be significant, and taxes will be owed on the receipt of the shares. But for cash-strapped private startups, neither of these are possibilities.