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An employee stock option plan can be a lucrative investment instrument if properly managed. For this reason, these plans have long served as a successful tool to attract top executives, and in recent years become a popular means to lure non-executive employees. Unfortunately, some still fail to take full advantage of the money generated by their employee stock. Understanding the nature of stock options, taxation and the impact on personal income is key to maximizing such a potentially lucrative perk.What's an Employee Stock Option?
An employee stock option is a contract issued by an employer to an employee to purchase a set amount of shares of company stock at a fixed price for a limited period of time. There are two broad classifications of stock options issued: non-qualified stock options (NSO) and incentive stock options (ISO).
Non-qualified stock options differ from incentive stock options in two ways. First, NSOs are offered to non-executive employees and outside directors or consultants. By contrast, ISOs are strictly reserved for employees (more specifically, executives) of the company. Secondly, nonqualified options do not receive special federal tax treatment, while incentive stock options are given favorable tax treatment because they meet specific statutory rules described by the Internal Revenue Code (more on this favorable tax treatment is provided below).
NSO and ISO plans share a common trait: they can feel complex! Transactions within these plans must follow specific terms set forth by the employer agreement and the Internal Revenue Code.
Grant Date, Expiration, Vesting and Exercise
To begin, employees are typically not granted full ownership of the options on the initiation date of the contract (also know as the grant date). They must comply with a specific schedule known as the vesting schedule when exercising their options! . The vesting schedule begins on the day the options are granted and lists the dates that an employee is able to exercise a specific number of shares. For example, an employer may grant 1,000 shares on the grant date, but a year from that date, 200 shares will vest (the employee is given the right to exercise 200 of the 1,000 shares initially granted). The year after, another 200 shares are vested, and so on. The vesting schedule is followed by an expiration date. On this date, the employer no longer reserves the right for its employee to purchase company stock under the terms of the agreement.
An employee stock option is granted at a specific price, known as the exercise price. It is the price per share that an employee must pay to exercise his or her options. The exercise price is important because it is used to determine the gain (called the bargain element) and the tax payable on the contract. The bargain element is calculated by subtracting the exercise price from the market price of the company stock on the date the option is exercised.
Taxing Employee Stock Options
The Internal Revenue Code also has a set of rules that an owner must obey to avoid paying hefty taxes on his or her contracts. The taxation of stock option contracts depends on the type of option owned.
For non-qualified stock options (NSO):
The grant is not a taxable event.
Taxation begins at the time of exercise. The bargain element of a non-qualified stock option is considered "compensation" and is taxed at ordinary income tax rates. For example, if an employee is granted 100 shares of Stock A at an exercise price of $25, the market value of the stock at the time of exercise is $50. The bargain element on the contract is ($50 - $25) x 100=$2,500. Note that we are assuming that these shares are 100% vested.
The sale of the security triggers another taxable event: If the employee decides to sell the shares immediately (or less than a year from exercise), the transaction will be reported as a short-term capital gain (or loss) and will be subject to tax at ordinary income tax rates. If the employee decides to sell the shares a year after the exercise, the sale will be reported as a long-term capital gain (or loss) and the tax will be reduced. Incentive stock options (ISO) receive special tax treatment:
The grant is not a taxable transaction.
No taxable events are reported at exercise; however, the bargain element of an incentive stock option may trigger alternative minimum tax (AMT).
The first taxable event occurs at the sale. If the shares are sold immediately after they are exercised, the bargain element is treated as ordinary income.
The gain on the contract will be treated as a long-term capital gain if the following rule is honored: the stocks have to be held for 12 months after exercise and should not be sold until two years after the grant date. For example, suppose that Stock A is granted on January 1, 2007 (100% vested). The executive exercises the options on June 1, 2008. Should he or she wish to report the gain on the contract as a long-term capital gain, the stock cannot be sold before June 1, 2009. Other Considerations
Although the timing of a stock option strategy is important, there are other considerations to be made. Another key aspect of stock option planning is the effect that these instruments will have on overall asset allocation. For any investment plan to be successful, the assets have to be properly diversified. An employee should be wary of concentrated positions on any company's stock. Most financial advisors suggest that company stock should represent 20% (at most) of the overall investment plan. While you may feel comfortable investing a larger percentage of your portfolio in your own company, it's simply safer to diversify. Consult a financial and/or tax specialist to determine the best execution plan for your portfolio.
Bottom Line
Conceptually, options are an attractive payment method. What better way to encourage employees to participate in the growth of a company than by offering them a piece of the pie? In practice, however, redemption and taxation of these instruments can be quite complicated. Most employees do not understand the tax effects of owning and exercising their options. As a result, they can be heavily penalized by Uncle Sam and often miss out on some of the money generated by these contracts. Remember that selling your employee stock immediately after exercise will induce the higher short-term capital gains tax. Waiting until the sale qualifies for the lesser long-term capital gains tax can save you hundreds, or even thousands.
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AlamyA US Navy X-47B Unmanned Combat Air System aircraft is towed into the hanger bay aboard the aircraft carrier USS George H.W. Bush -- the first aircraft carrier to successfully catapult launch an unmanned aircraft from its flight deck. With a fiscal 2013 defense budget of nearly $614 billion, the United States is widely known to be a big spender on defense. By some estimates, U.S. defense spending accounts for nearly 60 percent of the $1.19 trillion the top 10 military powers spent on defense in 2011. In fact, our country allocates more than five times more money to defense than does its closest spending rival, China. And that's not the half of it. In the cutting-edge field of military unmanned aerial vehicles, the United States has such a huge lead over its rivals that it makes their combined UAV fleets look like a rounding error in a world that's essentially 100 percent dominated by U.S. drones. Pax Americana As The Wall Street Journal recently reported, the U.S. military commands a fleet of 429 "large drone" aircraft such as the General Atomics Predator and Northrop Grumman (NOC) Global Hawk. Meanwhile, America's smaller drones, built by everyone from Boeing (BA) to Textron (TXT) to tiny AeroVironment (AVAV), maker of the ubiquitous Raven man-portable UAV, number in the thousands. In contrast, the military of the United Kingdom, not even a U.S. rival but a close ally, boasts a fleet of precisely 10 large drones, most of which we built for them, and the rest imported from Israel. Italy has nine, France, four, and Germany has three. As a result, when allied forces need a drone to "put eyes" on a target, more often than not, they have to ring up the U.S. military to get one. Who You Gonna Call? For allied nations, that has to be embarrassing -- but it's a situation unlikely to change soon. As the Journal reports, European defense giant European Aeronautic Defence & Space (EADSY), the parent company of Airbus, is only just now beginning to test a prototype pilotless helicopter -- whereas in the U.S., pilotless helos from Northrop called "Fire Scouts" have been in active service for years. True, European defense contractors such as EADS, BAE Systems (LSE: BA), and Dassault Aviation have succeeded in putting a few smaller drones in the air, and have dreams of prototypes of larger craft. But budget cuts, exacerbated by an ongoing economic crisis and also "territorial" squabbling among EU governments over ownership of defense companies, have hobbled the Continent's ability to develop robotic aircraft of any real size or capability. By some estimates, Europe is as much as 10 years behind the U.S. in drone technology development. The World Is Our Unmanned Oyster In the absence of a "homegrown" drone program, Europe remains largely dependent on the kindness of strangers for its drones -- in other words, the willingness of U.S. companies such as Northrop and General Atomics, and Israeli firms like Israel Aerospace Industries, to sell them the large drones they need. Right now, France is in the process of petitioning the U.S. Congress to sell it 16 General Atomics Reaper drones. If and when the sale goes through, though, it should mean at least $1.5 billion for General Atomics. In future years, U.S. defense contractors could rack up even bigger sales. Australia, for example, already a patron of Israel's IAI, is gearing up to spend hundreds of millions of dollars on a new maritime surveillance drone (dubbed "BAMS") being developed by Northrop Grumman. Aerospace consulting firm Teal Group, based in Reston, Va., estimates that by 2023, the global drone market could grow to as much as $11.6 billion in annual sales. For the time being -- and perhaps for as much as a decade in the future, until Europe catches up -- most of these sales should be ours for the taking.
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