Understanding Stock Options
Understanding Stock Options
By: Carl Hostetter, Vice President

If you are a corporate executive or plan to be one someday, a substantial portion of your compensation may be provided in stock options. Are stock options the same as good old cash? Not exactly. Traditionally, stock options have been used as a way for companies to reward top management and link their interests with those of the company and other shareholders.

Basically, a stock option gives you the right to buy a certain number of the company's shares at a fixed price for a certain number of years. The price at which the option is provided is called the "grant price," and it is usually the market price at the time the options are granted. Option rights are usually vested, meaning only a certain percentage of the options can be exercised at different points in time. There is usually a time limit on the exercise of the shares, typically 10 years from the date the options were granted.

There are two principal types of stock options - "incentive options" and "non-qualified options" - each with unique rules and tax consequences. With incentive options, you are not required to pay taxes on the "spread" between the grant price and the exercise price until the shares are sold. Capital gains taxes would then be due. With non-qualified stock options, you must pay taxes on the spread each year, just as if it were income or wages.

Do you actually own the options? Yes and no. Until you exercise your stock options, they remain on the company's books as an asset of the company and a benefit to you. Only when you own the options are they considered an asset in your portfolio. This is why it is tricky to determine the actual value of the stock options in your portfolio.

An option status statement should be used as a supplement to your personal financial statement to help you accurately determine your total wealth. An option status statement will typically include the following information about your stock options:

In this way, you can easily see which options you own (that is, the number of options you have exercised) as an asset, and which options remain as assets of the company and potential future assets of yours. Options should be exercised on a regular basis to manage the asset consistently and properly.

The usual timeframe within which options should be exercised is 10 years. The exercise can be a cashless transaction, where the difference between the price of the options and the current market value of the stock is paid in cash. Non-qualified options can be exercised for cash or held in certificate or book-entry form. However, the spread between the option price and the market value is subject to ordinary income tax. Incentive stock options may also be exercised as a cashless transaction, but this would be subject to income tax.

For example, assume that you were awarded 10,000 shares at a price of $8.00 per share. At the time you exercise the shares, the current market value of the stock has risen to $80.00 per share. The difference between the option price and the current market price ($720,000) would be considered ordinary income and would be taxed accordingly. Taking this example one step further, assume that you exercised your options to fund the acquisition of a major asset. Practically speaking, the true cost of the asset you acquired should include the aggregate of the tax liability.

Capital gains taxes also apply when you exercise stock options. You can hold this capital gains tax to a minimum if you exercise your options by purchasing and holding them for one year. Using our example from above of 10,000 shares with an option price of $8.00 per share and a current value of $80.00 per share, the short-term capital gains tax on the exercise would be at ordinary income rates, as high as 35% percent, or $252,000. An alternative would be to finance the original cost of the shares ($80,000) at the prime interest rate (say, 3.25%), amounting to an annual interest expense of $2,600. By financing and holding the stock for one year, your net short-term capital gains tax savings would be $249,400. After paying the long-term capital gains tax of 15%, your net savings would be $141,400. The interest expense incurred in financing the options would be tax-deductible as an investment expense. After one year, you would only need to sell 2,383 shares of your 10,000 total shares to pay off the loan and pay the tax. That would leave 7,617 shares remaining unencumbered.

As you can see, understanding stock options and determining their value to you can be somewhat complicated. If stock options comprise a portion of your compensation, it is imperative that you understand what you own and how to value it within your overall financial picture. If options are valued correctly and exercised in ways that minimize the tax consequences, they can be a valuable portion of your overall wealth.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.

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