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May, 2010
Understanding Your Employee Stock Options

If you receive employee stock options as part of your compensation package, it's important to understand that your management of this benefit can affect your cash flow, taxes, and other financial issues. Because there are many different exercise strategies, careful planning is crucial in receiving the most value from your options.

A Contractual Agreement

Employers that provide stock options frequently do so with the goal of giving employees a stake in a company's financial success. A stock option is a contract that grants the right to purchase a set number of shares of company stock at a specific price for a duration of time. There typically are two types of stock options: nonqualified stock options (NQSOs) and incentive stock options (ISOs). Before exercising stock options, it's important to know which type you have because ISOs and NQSOs are treated differently for tax purposes. If you have questions, read the option agreement or ask your employer.

Although there are exceptions, ISOs frequently receive more favorable tax treatment. With an ISO, an employee typically receives a grant with the option to purchase a specific number of shares for a pre-established price for a period of time that is specified in the option agreement. For ordinary income tax purposes, you do not report taxable income until you sell the stock, when a capital gain (assuming the stock increased in value) may come into play. However, you may need to pay attention to the alternative minimum tax (AMT).

Beware the AMT

Holders of ISOs need to understand that their basis for purposes of the alternative minimum tax (AMT) may differ from their basis for regular income tax purposes. Taxpayers must report the difference between the fair market value of the stock and the option price as an adjustment in figuring the AMT when their rights in the stock are transferable or no longer subject to substantial risk of forfeiture. However, no adjustment is required if you sell the stock during the same year in which you exercise the option. Also, there may be exceptions to some of these rules when option holders do not satisfy the holding period requirement specified in the contract or when stock options are granted at a discount. Because taxation issues regarding the exercise of stock options are complicated, you may want to consult a tax advisor regarding your situation.

With NQSOs, employers are required to report on their employees' W-2 forms the difference between the exercise price as defined in the option agreement and the market value on the day the options are exercised. In many instances, this difference, known as the compensation element, is the discount that employees get if they exercise the option at a price that is below market value. Employees typically owe income taxes, Social Security, and Medicare taxes on the compensation element. Taxation issues when employees ultimately sell the stock depend on the timing of the sale and the amount of any gain or loss.

When exercising stock options, there are many strategies available. Regardless of which strategy you choose, you may want to consult a financial or tax advisor to help you understand:
  • Cash required to exercise your options
  • Taxation issues, especially the alternative minimum tax
  • What happens if the options contract expires with no action on your part
  • The percentage of your portfolio that you want to allocate to employer stock
Your financial advisor can help you analyze these issues with the goal of maximizing the benefit of your stock options.

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Kelly C. Ruggles is a fee-based financial planner located in Spokane.
Kelly C. Ruggles, President of American Reliance Group, Inc., a registered investment advisor.
Kelly Ruggles is the author of "The Financial Playbook" for Retirement

Kelly C. Ruggles does not intend to provide personalized investment advice through this publication and does not represent the strategies or services discussed are suitable for any investor. Investors should consult with their financial advisors prior to making any investment decisions.