Guest post from Brian Betz, CFP® with Percension Wealth Advisors, LLC
You work for a successful, start-up company. When hired you were given a pile of stock options, at which point the dollar signs in your head began swirling. After years of growth, your company finally went public! As your coworkers pop champagne you know this is good news but you are still not totally sure what it all means. Allow me to help you navigate your stock option situation.
To review, stock options are the right to purchase shares of a particular company stock, at a particular price (“exercise” or “strike” price). There is a “vesting” period, which means you must continue working for your employer for a specified period of time before your right to purchase comes available. Once that date arrives, there is typically a 10-year timeline to exercise the options. That purchase window reduces to three months from date of departure if you leave the company. To be clear it is your right, not an obligation to exercise options. The presumed value is that the price you pay will be lower than the market value on the date you buy them, netting you a tidy profit.
Calculating whether it is valuable to exercise your stock options is the easy part. The trickier, often overlooked piece is determining the tax implications of doing so. Taxation will largely depend on whether you own incentive/qualified stock options (ISOs) or non-incentive stock options (NSOs). Here are some of the key differences:
Incentive Stock Options (ISOs)
- May only be issued to employees
- Generally more favorable tax treatment than NSOs, by receiving long-term capital gains tax treatment (15% tax for most taxpayers) if you meet the required holding periods
- To receive long-term capital gains treatment when you sell your purchased shares, the sale must be: 1) at least 2 years from the original date you were granted the options, and 2) at least 1 year from when you exercised the options (the “2/1” rule)
- If the above 2/1 rule is not met, the difference between the market value on the date you exercise and the exercise price itself is taxed as ordinary income. Any additional gain between that market value and the price you eventually sell for is taxed as either a short-term or long-term capital gain. Short-term capital gains are taxed as ordinary income, which is likely a higher percentage than the favorable 15% long-term capital gains rate
Non-incentive Stock Options (NSOs)
- May be issued to anyone (employees, vendors, board of directors, etc.)
- When options are exercised, the difference between the market value and the exercise price is taxed as ordinary income in that year
- When shares are eventually sold, the difference between the sale price and the market value on date the shares were exercised is taxed as either a short-term or long-term capital gain
The biggest benefit to ISOs is the fact that all gains can be treated as long-term capital gains if the required holding periods are met. Additionally, unlike NSOs, you do not have to recognize any ordinary income when shares are exercised. This makes for a smoother decision-making process when balancing investment gains with the corresponding tax implications. Bear in mind there may also be Alternative Minimum Tax (AMT) consequences, but that is beyond our purposes here. Furthermore, here we assume that you ultimately sell your purchased shares for a gain, not a loss.
If you are still unclear, here are 5 easy steps to gain a better understanding of your stock options:
1. Ask Human Resources to confirm whether your shares are ISOs or NSOs
2. Confirm the number of options you own
3. Learn the vesting schedule
4. Identify your strike price
5. If your company has already gone public, keep track of the market value (stock price)
If you work for a start-up company you most likely own ISOs. Provided you have the cash to buy the shares when the vesting date is reached and provided you are “in the money” (market value > exercise price), it is a good idea to exercise and start the one-year clock toward attaining long-term capital gains treatment. As always, the decisions of whether to exercise, when to sell and the associated tax implications are unique to each individual investor’s specific financial needs.
Brian Betz is a Certified Financial Planner™ and founder of Percension Wealth Advisors, LLC located in Seattle, WA. Prior to forming Percension, Brian worked for nearly a decade in both personal and corporate finance across Seattle and the San Francisco Bay Area. He holds a double degree from Santa Clara University – Bachelor of Science in Finance and a Bachelor of Arts in Communication.
Brian Betz is not affiliated with The Astute Advisor or Bridgeview Capital Advisors, Inc.