The Basics of Employee Stock Options

A stock option is a contract between you and a company. This allows you the opportunity to buy a fixed number of shares at a specified price.

But the option will likely have vesting. This means you need to work for the company a certain period of time to get ownership.

To understand this, let’s take an example. Let’s say you get a job at an exciting startup, which is Cool Corp. The company grants you an option to purchase 20,000 shares for $1 each, which is the exercise price. You usually have ten years to exercise the option (as we saw in our example with Musk).

When you receive a stock option grant, there is generally no taxes owed. Rather, the taxes come when you exercise the option and sell the stock. We’ll cover this later in the chapter.

In terms of vesting, a company will have a fixed period of time. It’s common for this to be four or five years. In our example, if the vesting is for four years, then at the end of each year, 25% of the option will vest or 5,000 shares (20,000 multiplied by 25%).

Suppose a year passes, and you get your first vesting. The stock price has gone to $4, and you have a gain of $15,000. This is $4 minus the $1 exercise price – which is then multiplied by 5,000 shares. Your option is considered to be in-the-money.

But this is a “paper” profit. You only make money when you exercise and sell the shares. To do this, you will need to fill out a form, which can be online or a physical document. There may also be a need for various legal signoffs, such as from the company’s counsel. This is especially the case if you work at a private company (later in this chapter, we’ll look more at the process of how to sell shares that are not publicly traded).

OK, in our example, let’s suppose that Cool Corp.’s stock price drops to 50 cents a share. There is then no value to your option and it would not make sense to exercise it. Your option is considered to be “under water.” This happens when the stock price falls below the exercise price.

Now that we have a backgrounder on employee stock options, the next step is to look at the different types: nonqualified options and incentive stock options.

Nonqualified Stock Options

A nonqualified stock option (NQSO) is an employee stock option that does not provide favorable tax treatment. This is the most common in Silicon Valley and for publicly traded companies. A NQSO can be issued to both employees and contractors like board members and consultants.

Here’s an example. Suppose you are an engineer at Cool Corp. and the company grants you a NQSO for 1,000 shares and the exercise price is $25. When the first 250 shares vest after a year, the stock price for Cool Corp. is at $35 per share. This means your gain is $250, as seen below:

Proceeds from the Exercise (250 shares X current stock price of $35)

$8,750

Minus

Purchase Amount of the Exercise (250 shares X the exercise price of $25)

$6,250

= $2,500

As you can see, the tax rates increase as your income rises. This is because the United States has a progressive system. For example, if you are married and file a joint return, then the first $20,550 will be taxed at 10%, the income from $20,551 to $83,550 is taxed at 12% and so on.

Let’s take an example of how to calculate your taxes. Suppose you and your spouse have a combined income of $220,000. First, you will go to the second column in the chart and select the one where $220,000 fits. This is for the 24% bracket. Next, go to the second column and then use the tax for $30,427. This is the tax for all the prior rates up to $178,150. Then you will add the tax of 24% on anything above this, which is $41,850 ($220,000 taxable income minus $178,150) multiplied by 24% or $10,044. This provides a total tax of $30,427 plus $10,044 or $40,471.

Let’s return to our example with Cool Corp. Since you are an employee of the company, it will use withholding for the $2,500. This means it will take a portion out of your paycheck for income taxes, state taxes, Social Security, and Medicare.

In all, you may owe a considerable amount in taxes. This is especially the case if the bargain element is in the six figures, which is not uncommon for tech companies.

Note that the amounts withheld may be too low and this could mean having to owe more taxes when you file your 1040 return. You could also owe penalties and interest. To avoid this, you use estimated payments. You will file Form 1040-ES with the IRS, which you can do via mail or online. You will need to do this if you owe more than $1,000 in federal taxes for the year. Online systems like TurboTax or HRBlock.com can handle the calculations and process.

Let’s continue with our NSQO example. You now own 250 shares of Cool Corp. You then wait a few months and sell them. What happens? It depends on the price of the stock.

If it is higher than the price of the date of the exercise, you will have a short-term capital gain, and this will be taxed at your ordinary rates. However, if you sold the shares more than a year later, there would be a long-term capital gain and the tax rate would be lower. For the most part, a key strategy is to try to find opportunities for long-term capital gains.

The tax is based on the amount realized – which is what you sold the shares for – minus the cost basis. The cost basis is what you paid for the shares.

But there is a hitch. True, when you exercised the NSQO, you paid $6,250 for the shares. You also paid taxes on the $2,500 bargain element.

So, what is your cost basis? It’s actually $8,759, which is the $6,250 plus $2,500.

Keep in mind that some taxpayers miss this. And this means paying a higher tax.

Let’s continue with our example. Suppose you sell your 250 shares at a price of $50. Your amount realized is $12,750. In this case, you will owe taxes on a capital gain of $4,000 or $12,750 minus the cost basis for $8,750.

Now if you sold the 250 shares at a loss, you can offset this against other capital gains. However, if after doing this you still have losses, you can take up to $3,000 on your return. Anything else you can carry forward to future tax years.

In terms of reporting these transactions, you will receive a 1099-B form from your brokerage firm. You will then use this to report you gains and losses on IRS Form 8949 and Schedule D for your 1040 tax return.

Using Stock to Exercise Nonqualified Stock Options

You may be able to use stock to exercise an NSQO. Suppose that you already own 100 shares of Cool Corp., for a total value of $2,500. You can use 40 of these shares for the exercise of the NSQO. This means the total number of Cool Corp. shares will come to 160. This includes the 100 shares you already own minus 40 shares for the exercise and plus 100 shares you get from the exercise. Now you will still need to come up with cash to pay for the withholding, if you are an employee.

So why do this kind of transaction? Well, there are two key reasons. First of all, you may not necessarily want to come up with the cash for the exercise.

Next, there are tax considerations to take into account. For example, the exchange of the shares you own for the new ones is actually a tax-free transaction. The new shares have the same basis and holding period as the old shares.

Then, the additional shares you acquired from the exercise will have a holding period that starts at the time of the exercise and the cost basis will be the compensation income recognized.

Incentive Stock Options (ISOs)

With incentive stock options, you have the potential to get long-term capital gains treatment. But this does not come for free. You will also be subject to the Alternative Minimum Tax (AMT), which can be complicated and result in a higher tax bill.

If you are not sure if your option is an ISO, then check with your HR department or representative.

This type of option also has the so-called “$100,000 Rule.” This means that only up to $100,000 worth of an exercisable option may be deemed an ISO each year. Anything above this is a nonqualified option.

Let’s take an example. You receive an option for 20,000 shares of Cool Corp. – with an exercise price of $15 – that vest over 4 years. This does not violate the $100,000 rule since, every year, the amount of vested stock is $75,000 or 5,000 shares per year multiplied by the $15 exercise price.

But then suppose your employer makes another grant for 4,000 shares, with an exercise price of $30. Each year, the total vested amount will be $105,000 or $75,000 plus $1,000 multiplied by $30 exercise price. In this situation, the $100,000 of your options will be treated as an ISO and the remaining $5,000 will be considered a nonqualified option.

There is an easy way to avoid having an ISO be subject to AMT. This is when you exercise the option and sell all the shares in the same year. This is known as a disqualifying disposition.

ISOs and AMT

Taxes can get quite complex with ISOs. Even experienced tax professionals have challenges with this part of the tax code. The main reason is how AMT works. So in this section, we’ll take a look at some of the main scenarios.

But first, let’s get an overview of AMT. It is a tax system that Congress legislated in the late 1960s. The goal was to prevent wealthy individuals from paying little or no taxes. This is where the “minimum” in AMT comes from. Essentially, Congress wanted to make sure that every taxpayer paid their fair share.

AMT is actually a separate tax system (hence the word “alternative”), and this certainly adds to the difficulties. And yes, there are many critics of AMT. The Tax Policy Center has called it "the epitome of pointless complexity."⁴

Unfortunately, this is spot-on. However, if you have ISOs, then you need to understand AMT. If not, you can get into lots of trouble.

So, when does the AMT apply? This is not easy to answer. There are various rules on this. Basically, to truly know if the AMT applies, you will need to complete returns for both the federal tax system and AMT.

Regardless, there are certain factors that may potentially trigger the tax. They include the use of state and local state tax deductions, property taxes, the amount of interest on a second mortgage and, of course, the exercise of ISOs.

The AMT involves a multi-step process, which is done by filling out Form 6251. For the first step, you take your adjusted gross income (AGI) and then make certain adjustments or tax preferences, such as disallowing various deductions but also including income items like the gains from the exercise of an ISO. After this, you will get an amount called your Alternative Minimum Taxable Income or AMTI. You will subtract this by an exemption amount. For 2022, it is $75,900 if you are single and $118,100 if you are married and file jointly. But this amount phases out based on your AMTI. It comes to 25 cents per dollar earned when AMTI hits $539,900 for single filers and $1,079,800 for those who are married and file jointly.

Next, you will multiply the net amount of the AMTI by the AMT rate, which is either 26% or 28%. If you have an AMT foreign tax credit, you subtract it from the tax you owe.

Now let’s see how much you may pay. For example, let’s say you owe $45,000 in federal tax and your AMT amount is $40,000. In this case, you actually have no AMT.

But let’s say in the following year you exercise an ISO and generate substantial income. Because of this, your federal tax is $125,000 but the AMT is $150,000. According to the IRS, you must pay $125,000 in federal tax and $25,000 in AMT (which is the total AMT minus the federal tax).

OK then, why is AMT a problem if the maximum rate is 28% when the maximum for the regular tax system is a much higher 37%? Some of the reasons include the phaseout of the exemption as well as the inclusion of the income from the exercise of the ISO.

So, when it comes to AMT, it is important to be diligent and to do your research. Or, if things get too complex, then it is a good idea to seek out advice from a tax professional. The fee for the service should be well worth it.

Next, let’s take a look at some of the scenarios for ISOs. Suppose you get an ISO grant for 5,000 shares from Cool Corp. and the exercise price is $25. After a year, you exercise 1,000 shares while the stock price $60. Your bargain element is $35,000, which is $60,000 minus the $25,000 for the purchase price.

You hold onto the shares for the rest of the year. In this case, you will not report the $60,000 for federal tax purposes. You also do not have to pay Social Security or Medicare taxes. Your W-2 will also not disclose the bargain element as income.

However, the $60,000 bargain element will be an adjustment for AMT. Consider that this may not necessarily mean you have to pay this tax. Again, you will only need to do this if the overall AMT amount is higher than the federal tax, which could be based on various other factors than your stock options.

In our Cool Corp. example, the $60,000 would be treated as a long-term capital gain, so long as you meet the above requirements. But this type of a transaction can be risky. For example, suppose you exercise the option, and you paid a substantial amount of AMT. But when holding onto the stock for a year after the exercise, the price plunges. Unfortunately, you would have paid taxes on a “phantom gain.” That is, you paid taxes on the AMT even though you did not receive any cash.

You might be able to recapture some or all of this. The reason is that the amount of the AMT that exceeds the regular federal tax could become a tax credit (to calculate this, you use IRS Form 8801). You can use this to reduce future federal tax liabilities. But it may take a while to get the full benefit. To make sure you maintain it, you will need to keep filing Form 8801 and Form 6251. All in all, this is a complex area of the tax code and it’s usually a good idea to get the help of an expert.

Restricted Stock

When a company grants you actual shares, they are referred to as restricted stock. There are two types: restricted stock units (RSUs) and restricted stock awards (RSAs).

Let’s first take a look at RSUs. With these, you will get access to the shares when you meet certain requirements. The most common is that you have worked for the company for a specific period of time.

Then what are the other conditions that might apply? Well, a company may require that the company hit a sales level or a number of customers.

Before you meet the restriction on the RSUs, you do not own any of the shares. This means that you will not receive any dividends. These will only come after you get ownership. Although, a company may have a policy to pay a cash amount to you anyway.

As for taxes on RSUs, you do not owe anything for the grant. It’s only when the shares vest that you will need to report ordinary income, which is the fair market value of the stock (you can subtract the amount paid for the shares, if this applies). Your employer will disclose this amount on your W-2.

You may owe more tax when you sell the shares – that is, if the stock price is higher. If this is done less than a year from the vesting, it will be a short-term capital gain.

OK, now let’s take a look at RSAs. Sometimes they are called a stock grant or restricted stock. But for our purposes, we’ll refer to them as RSAs.

Then what is the difference with the RSU? Well, with an RSA, you get the shares upfront. However, if you do not meet the requirements, you will forfeit them. For both RSUs and RSAs, the most typical condition is that you work for the company for a period of time.

Even though you get a stock grant with an RSA, the physical shares will likely remain with a third-party, such as an escrow agent. The main reason is that this provides a better way for the company to initiate a forfeiture. However, since you are still the owner of the shares, you will get any dividend payments.

Regarding taxes on RSAs, the rules are the same as for RSUs. You do not pay taxes on the grant. But you do so on the vesting for the fair market value of the stock.

Something else you should know is the Section 83(b) election. This is for RSAs or stock grants that allow for an early exercise.

Keep in mind that this is a very important part of the tax code when it comes to equity compensation. Also, this is usually for early-stage startups. All in all, it can mean big tax savings.

For example, suppose you get an RSU for 100,000 shares at 5 cents each. Then the startup takes off and when the first 25,000 shares vest, the stock price is at $1. In this case, the whole $25,000 is subject to your ordinary tax rate, which could be as high as 37%.

But had you filed a Section 83(b), then the situation would have been much different. In this case, you would owe ordinary income taxes on the $5,000 value of the shares at the time of the grant, or 100,000 shares multiplied by 5 cents each. Then any gain above this would be treated as a capital gain. If you hold onto it for over a year, then the maximum tax rate would be 20%.

Now, when it comes to a section 83(b), there are strict rules. First, you need to write a letter to the IRS about the transaction. This is usually less than a page. Then you need to send it to the IRS within 30 days of the grant. There are no exceptions.

Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) are generally for companies that are traded on an exchange, like NASDAQ or the New York Stock Exchange. They are actually a nice perk for employees. It allows for the purchase of company stock for up to a 15% discount. This is done through after-tax income and a payroll deduction. This can be a good way to build an equity stake in your employer.

Even though you get a discount, the IRS does not treat this as a taxable gain at the time of the purchase. This is so long as the ESPP is a qualified plan. Make sure to check this with your HR department.

All employees are usually allowed to participate in an ESPP. But if you have more than a 5% stake, then you cannot.

There are timing rules, though. For example, you can only enroll in an ESPP during certain parts of the year. Also, you will usually sign up through a brokerage account that is approved by your employer.

An ESPP program will have requirements on amounts for the contribution. It’s common, though, for this to be at least 1% of your compensation or up to 15%. However, in any given year, the purchases cannot exceed $25,000.

What about when can you sell your shares? In general, you can do this any time. Yet if you want to maintain the favorable taxes – such as for the 15% discount – then the sale should be one year after the purchase and two years after the grant. If so, the gains will be taxed at long-term capital gains rates.

Preferred Stock and Equity Compensation

In Chapter 1, we looked at preferred stock. This was in terms of publicly traded companies. But keep in mind that venture capitalists will often receive preferred stock for their investments and there are usually more preferences and benefits. After all, these startups are high risk.

For those who work at startups, it’s certainly important to understand the investment terms. Even if a company is acquired, you may ultimately wind up with worthless options or other equity.

An example is Good Technology. This mobile security startup sold to BlackBerry for $425 million in 2015.⁵ On the surface, it seemed like a good deal for employees. But because Good Technology raised substantial capital at robust valuations, there was little left for the employees. Their options were worth 44 cents a share while the venture capitalists’ holdings were at $3 a share. Even worse, some employees even lost money because they had to pay taxes on inflated gains (one person’s tax bill exceeded $150,000).

SPACs (Special Purpose Acquisition Companies)

You may work for a company that is a SPAC (Special Purpose Acquisition Company). This means that it went public in a different approach than a traditional IPO. Although, the common stock you receive is the same – and you can receive any type of equity compensation that’s been mentioned in this chapter.

While the SPAC structure has been around since the early 1990s, it has gained in popularity since the emergence of the COVID-19 pandemic. The main reason is that it is easier in terms of the paperwork, due diligence, and regulations.

Here’s how a SPAC works. There will be a sponsor, which includes a group of people who are usually experienced in business (say as CEOs or senior executives). They will then create a shell company that has no operations and retain a 20% equity stake in it. The sponsor will use this as a way to focus on a certain industry or market opportunity.

The SPAC will then raise capital on the NYSE or NASDAQ. A large amount of the equity will usually be sold at $10 a share and then there will be a warrant attached to the offering. This is similar to an option, in which the holders of the shares can buy extra stock. The strike price of the warrant is often at $11.50 a share.

After this, the managers will seek out an acquisition candidate. They also have two years to take this action. If there is no deal, then the SPAC will need to return the funds to the shareholders.

For example, suppose Cool Corp. is a SPAC and it agrees to merge with ABC Corp. The shell will be renamed as ABC Corp. (by regulation, at least 80% of the proceeds of the public offering must be used for the deal). As a result, ABC Corp. is now publicly traded – but did not have to do this with the traditional IPO approach.

If the stock price of the SPAC increases, then the warrant can provide a nice additional return. Moreover, there is a redemption right, in which investors can agree to get their money back if they do not agree with the acquisition.

As for the disadvantages, there can be undue pressure on the managers to get a deal done. This may ultimately mean buying a company that is not a good long-term prospect.

There has also been more regulatory scrutiny of SPACs. There are concerns that the managers may not be doing enough due diligence or that the disclosures are not sufficient.

Liquidity Services

There are a variety of online platforms that help you sell your privately held shares. Some examples include EquityZen, Nasdaq Private Market, CartaX, and Forge Global.

These platforms have become very popular over the years. One reason is that many startups have waited to go public. Yet many employees still want to find ways to cash in their equity holdings, such as to diversify their assets or make a purchase (say for a home or car).

The fees for such a transaction? It is usually a percentage of the amount sold – say 5% or so. The transaction process can also take one to two months.

For some platforms, there may be private loans. This is to allow for the exercise of the options. Given the high valuations of startups, many employees simply do not have enough available cash to make a transaction.

Negotiating Equity Grants

When you get an option grant, you should negotiate the terms. You could wind up with much more value from the equity.

True, when you get a grant, it may seem like a lot of shares. This is especially the case with an early-stage startup. For example, the option grant could be something like 20,000 or 50,000 or more shares. And yes, even if there is a $1 gain, this can mean a lot of money.

But do not be too focused on the absolute number of shares. Basically, you want to know another important number: how many shares of the company’s stock have been issued. For example, if a company has 500 million shares outstanding, then your 20,000-option grant would represent a very small percentage of the equity of the company. In other words, ask the company for how many shares are outstanding. If the grant pales in comparison, then you can use this as a way to bump up your number.

Now, if this is not applicable, you should still negotiate on the number of shares anyway.

Something else: When you negotiate for more shares, you should also bring up that you will be taking on risk. Let’s face it, a company’s stock can be volatile or go out of favor. You are also likely taking a lower salary in exchange for your options. Bottom line: As much as possible, fight for more shares!

As time goes by and you get promoted and show your value to the company, then talk about another option grant. There is no reason why you can’t have multiple ones.

Vesting is another critical area for negotiation. You want to get the value of your options as soon as possible. To this end, you can ask for a vesting schedule of three years or even two years. You should also request monthly vesting.

Finally, look to get accelerated vesting for your options. This means that all the shares are vested on an event, such as the acquisition of the company or an IPO.

Concentration Risk

Concentration risk means that you own an asset that represents a large percentage of your total assets – say over 20%. If the asset plunges in value, you would suffer a major loss. It could be a significant setback in achieving your financial goals.

In the tech world, concentration risk is actually common. A seemingly invincible company can quickly fall apart. Just look at what happened to BlackBerry and Yahoo!

Yet the temptation is to hold onto the options or stock too long. But when a tech company stumbles hard, it’s very tough for a comeback.

This is why it is a good idea to consider selling your position when there is concentration risk. What’s more, you should allocate the funds to holdings that are non-tech.

Another strategy for reducing concentration risk is to donate part of your stock to a charity. This can reduce your taxes and provide estate planning benefits. There are a variety of trusts and investment vehicles that can help with this, such as a donor-advised fund, private foundation, and a Charitable Remainder Trust.

You may also set up a collar on your stock position, which is a sophisticated hedging strategy. This is what Marc Cuban used in 1999. He sold his startup, Broadcast.com, to Yahoo! and his stock was worth about $1.4 billion. He setup a collar, which capped his potential gains $205 a share and provided for a floor of $85 a share.⁶ Not long after, the dotcoms imploded, and Cuban was able to preserve about 90% of his wealth.

For executives, it can be difficult to deal with concentrated positions. One reason is that there is often a negative perception if they unload their stock. Wall Street may see this as a sign of a lack of confidence in the prospects of the company.

To help deal with this, there is the 10b5-1 plan. An executive can set this up to allow for periodic sales of the shares.

But there can be no change of the amounts. An executive also cannot setup a 10b5-1 plan when they have access to nonpublic material information. Often this means that it should be after the latest earnings report or a major announcement.

Borrowing Against Your Equity

It’s known as the “buy, borrow, die” strategy. This is where you borrow against your equity holdings to pay for your ongoing living expenses. Assuming your equity holdings are large enough, you may be able to do this without ever having to pay back the loan. You also may not have to pay taxes, unless you have enough assets to be subject to the estate tax.

This strategy is not new. But it has traditionally been mostly for the mega wealthy. However, as Wall Street has looked to grow, it has offered lending options to more and more clients.

The loans are lines of credit that are called securities-based loans. Such arrangements usually have little paperwork because of the use of stock as collateral. As for clients, they can borrow up to a certain amount – say to 50% of the overall value. The interest rates are typically competitive as well.

With a securities-based loan, you will have a check book or debit card that you can use for your purchases. It’s all very simple and convenient.

But there is a risk. If the stock price plunges, you will likely need to put up more collateral for your loan. And if you do not do so – or do not have enough assets – you will be forced to sell your stock. This often comes at the worst time. It could mean having a huge reduction in your equity holdings.

Conclusion

In this chapter, we have covered the main types of equity compensation, such as incentive stock options, nonqualified stock options, restricted stock, and ESPPs. We have also looked at preferred stock – for startups – and SPAC structures.

Ultimately, the equity can result in substantial gains in wealth. But you need to be aware of the tax consequences. If you have ISOs, then you may be subject to AMT. For the most part, you will probably need the help of a tax expert.

You can also use strategies to borrow against your holdings. While this has its advantages, it could also mean being exposed to substantial risks if the markets come under pressure.

As for the next chapter, we’ll take a look at estate planning.