Many employers offer their workers the chance to literally “own part of the company.”
It can be good to have options.
In this case, we’re talking about employee stock options, which many companies offer workers as part of their compensation package. In a typical plan, management grants its workforce the right to buy stock at a specified price (the exercise price) by a certain time (the expiration date). In many cases, the opportunity to buy the stock extends for up to 10 years. If the company is doing well, the fair market price (the price of the stock on a securities exchange) could be above the exercise price, creating profit for the worker.
“The attractiveness of an employee stock-option plan depends on the performance of the company,” says Kristin Wagner, Manager of the Executive Services Team of Wells Fargo Advisors. “There could be a very large differential between the exercise price and the fair market price.” After an employee buys stock from the company, he or she is free to sell all or some of the shares through a financial advisor or brokerage company.
Once management grants a stock-option package, vesting requirements vary, with some companies allowing employees access to options immediately, while others might require a waiting period of several years. Expiration periods are typically shortened after an employee leaves the company. In all cases, however, shares acquired through an employee stock-option plan remain the property of the employee.
There are two types of employee stock-option plans. Incentive stock options are typically reserved for upper management, while nonqualified stock options may be available to all workers. Most of the differences between the two relate to taxes.
In a nonqualified plan, tax is due at exercise. For instance, let’s assume you exercised your right to buy 100 shares of the company’s stock at $50 per share on the same day that it is trading at $75 per share. In that case, you would immediately owe ordinary income and employment taxes on the $2,500 difference. If you hold the shares and sell your stock at $100 per share at least a year later, you would then pay tax at long-term capital-gains rates (currently 15%) on the difference between the fair market price at the time of sale ($100) and the fair market value at the time of exercise ($75).
With incentive options, all tax is deferred until the stock is actually sold. However, the alternative minimum tax (AMT) often applies to the purchase of stock acquired through incentive plans. Participants in incentive stock-option plans (also known as qualified plans) should consult their accountant to see if the AMT applies to their situation.1
Exercising Stock Options
Companies generally offer employee stock options for two main reasons. First, it gives the employee a stake in the company’s future. Second, stock options can be an enticing employee benefit. If the exercise price of the option is lower than the company’s fair market price at the time of purchase, employees are free to sell and make an immediate profit — or hold the stock in hopes of a higher profit in the future.
The three most common ways to purchase stock options are:
- Same-day sale. This is also known as a “cashless exercise.” The employee arranges to sell shares immediately after they are acquired. Money to exercise the stock options is actually borrowed from the brokerage firm, but the loan is quickly repaid using proceeds from the sale of the stock. Same-day sales often are made to “lock in” a profit resulting from a significant disparity between the exercise price and the current fair market value.
- Cash exercise. In this scenario, the employee uses his or her own money to pay for shares, and then either holds or sells the shares.
- Sell-to-hold. An employee may opt to sell some of the shares to pay for the purchase. Of course, this strategy only works if the underlying stock has appreciated. For example, an employee could buy 500 shares of stock at $10 per share, immediately sell 200 shares at a $25 market price to pay the bill, and then hold the remaining 300 shares.
There is another factor that employees should consider before exercising a right to buy their company’s shares. As with company-sponsored retirement plans like a 401(k), it can be easy for workers to acquire a significant amount of their employer’s stock. But in some cases, those holdings could come to represent a disproportionate share of the worker’s entire portfolio.
While individual circumstances vary, many experts agree that it is too risky to place more than about 10% of a portfolio in the stock of any one company, even your own. Of course, employees might feel that their close association with their company gives them a “heads up” on its prospects. Still, putting too many financial eggs in one basket is not a sound investment strategy.
1 Wells Fargo Advisors / Wells Fargo Advisors Financial Network does not provide tax or legal advice.
This communication is not a covered opinion as defined by Circular 230 and is limited to Federal tax issues addressed herein. Additional issues may exist that affect Federal tax treatment of the transaction. The communication was not intended or written to be used and cannot be used or relied upon by the recipient or any other person to avoid federal tax penalties.
The strategies discussed may not be suitable for your personal situation, even it is similar to the example presented. Investors should make their own decisions based on their specific investment objectives and financial circumstances. It should not be assumed that the recommendations made in this situation achieved any of the goals mentioned. This example is hypothetical and does not represent any specific investments or strategies.
This article was written by Wells Fargo Advisors and provided courtesy of Robert Sek, PIM – Portfolio Manager in Wayne.
Investments in securities and insurance products are: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE
Wells Fargo Advisors, LLC, Member SIPC, is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company.