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Integrated Wealth Management

Employee Stock Options

Many of our clients are awarded with employee stock options as part of their compensation package. Often recipients of stock option grants do not understand the characteristics of the options they received and do not have a strategy for exercising them.

Nonqualified Stock Options (NSO) vs. Incentive Stock Options (ISO)

Nonqualified Stock Options (NSO) can be granted at a discount to the stock’s market value (strike price). When you exercise the option, the difference between market value and strike price is taxed as ordinary income to you. When you sell the stock from the exercise, the profit is taxed as long-term capital gain if you hold it longer than one year.

Incentive stock options (ISO) qualify for special tax treatment - gains can be taxed at capital gain rates instead of ordinary income rates, which are usually higher. Also, there is no tax liability for receiving the grant or exercising the options. Taxes depend on when you exercise and sell the resulting stock. If you wait to sell your stock until a year after you exercised your ISOs, and this is at least two years after your ISO grant, any profit will be treated as a long-term capital gain. However, if you violate either time period you may end up paying ordinary income taxes on part of the proceeds.

When to Exercise?

Besides the vesting schedule, here are other factors to consider:

  • 2013 income taxes - if congress takes no action, income taxes will revert to the old rates of 15-40%; the long-term capital gain rate will be 20%; and dividends will be taxed at ordinary income tax rates. There will also be a new 3.8% tax on the net investment income and 0.9% Medicare tax on earned income for people who earn over $200,000 (single filing), or $250,000 (joint filing).  If you hold NSOs that can be exercised in 2012 or 2013, you may want to exercise in 2012 to accelerate the compensation - and avoid the 0.9% new Medicare tax and possibly higher ordinary income tax rates.
  • Company prospects - understand your company’s future potential – both on the upside and downside.
  • Volatility of the company stock - if the volatility is low, it is less likely to have spectacular upswings that you would miss out on if you exercised.
  • Dividend yield on the company stock - generally speaking, the higher the dividend, the greater the case for exercising. This is because a portion of the upside is already being paid out in the dividend, so there is less price appreciation potential.
  • Diversification - look at your overall portfolio; how much of your nest egg is in your company stock?
  • Current value (Black-Scholes model) vs. Intrinsic value (current stock price) - you can look at these ratios to determine the risk-reward trade-off of holding the option versus exercising it. The details of this analysis are beyond this post.

Still Not Sure?

You might be saying “that’s a lot of variables to take into consideration, how do I ever come to a decision?”. We are more than happy to sit down with you and go over your stock options. The main thing is to align your exercise strategy with your goals and manage the tax impact.