Two Types of Employee Stock Options (ESO)
It has been the tradition for companies to reward “key” employees and top management with stock options to align their interest with those of the company. Nowadays, companies are realizing that all employees are “key” employees and the number of people holding stock options has increased dramatically. More and more employers are awarding stock options to employees as part of their compensation programs. By purchasing stock in a company (exercising your options), you are becoming a partial owner in that company. If the company thrives and the value of its stock increases, you benefit.
There are two types of stock options.
Nonqualified Stock Options (NSOs) are the more traditional options, however, they do not meet IRS requirements that allow for special tax treatment. NSO’s exercised by employees are subject to FICA and FUTA taxes as well as Federal and State withholding just a cash wages would be. The employee is taxed when the stock options are exercised. The tax is on the difference between the fair market value when you exercise the stock options and the grant price.
Incentive Stock Options (ISOs) are allowed special tax treatment from IRS. You do not have to pay regular income taxes at the time you exercise, but you must hold your shares at least one year from the date of exercise and two years from the grant date in order to receive special tax treatment. If you wait and sell your options after the waiting period, you will be subject to capital gains tax on the difference between the sales price and the grant price. However, if you sell prior to the specified waiting period, you will be required to pay income taxes on the difference between fair market value at exercise and the grant price.
When you own stock in a company, you’re an investor. Thus, the more you know about how the stock market works, the better you will understand how your investment portfolio performs.
If you believe your company will experience long-term success , you might think twice about exercising your options immediately. If the company you hold stock in is likely to have success in the short term, that’s when it is advisable to exercise those options as quickly as possible. After purchasing stock, employees sometimes must hold on to their shares for up to several years before selling it for a profit.
As with all investments, there are risks. If the company fails or its stocks are devalued, then all investors could lose the money they put into them. Employees may also have taken stock options instead of a higher salary, and in that case would lose the money they could have made in their paychecks.