Cash in: maximizing employee stock options.

• Author: Pope, Devin
• Position: Money Talk

You've worked hard for your employer for several years and been rewarded with options on the company stock. Now stock options make up a large share of your wealth and you're thinking it's time to pay more attention. But what are these options worth and how should they be handled?

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As employers have grown more creative with compensation, questions like these no longer apply only to the executive suite. In many companies, options are now available to employees of all levels and for some represent a substantial portion of their total compensation package.

Understanding how stock options work and determining how to maximize their value can be complicated. While employee stock options can be great wealth-creation vehicles, understanding what they are and how they work will greatly increase the odds of a positive outcome.

Stock options grant the holder the right to purchase shares in a company at a specified price (exercise price) for a specified period of time (expiration). The aim of granting options is to incentivize employees, aligning their interest with that of the company. By doing so, the company hopes to increase operational performance and thus profitability.

Option Types

There are two types of options awarded: incentive stock options (ISOs) and nonqualified stock options (NQSOs). The key difference between the two is how they are treated for tax purposes.

ISOs

ISOs offer more favorable tax treatment than NQSOs, taxing the gain on the sale of the underlying shares at long-term capital gains rates if the holding rules are correctly followed.

There are two important holding periods to meet the holding rule requirement. The first holding period begins with the grant date of the option. The option holder must wait at least two years from the grant date prior to selling the underlying shares in order to have the gain taxed at long-term capital gains rates.

The second period begins when the stock is transferred to the employee. In order to receive long-term capital gains treatment, the shares must be held for at least one year following the date the stock was transferred. If the two holding periods are met, then the gain will be considered long-term.

Be aware that ISOs are an alternative minimum tax (AMT) preference item and in certain circumstances can trigger AMT.

NQSOs

NQSOs are less tax favorable, but are more commonly used as they are not subject to the same restrictions on issuance as ISOs. When a NQSO is...