Here’s some more information from Idiot’s Guides: Options Trading, on employee stock options.
Employee stock options are a special class of options. They give the holders the right, but not the obligation, to buy shares of the company in the future at a price predetermined today.
Companies often issue them as a form of incentive. If employees do such a great job that the stock price increases, then they can profit from it. But remember: exercising options creates a tax liability. Be prepared to pay the bill.
Typical Employee Option Setups
Employee stock options are privately negotiated call options. This means they give the holders the right, but not the obligation, to buy stock at a pre-determined date in the future at a price agreed upon today.
Let’s say your company issues you options today that allow you to buy 1000 shares of stock at $6.00 per share in six months. In six months, if the stock price is worth $$7.00, you could exercise the options, You would pay the $6.00 price, for a total of $6,000, and in exchange you would receive stock worth $7,000.
Most companies that issue stock options have a stock that trades on a recognized stock exchange, but not all do. An employer may give employees options that can be exercised for shares of private stock or that can be exercised when the company goes public or is sold. Unless one of those events takes place, the options will have no value.
Companies like to offer options because they are a form of compensation that does not involve any cash, and they give employees an incentive to work hard so that the stock price goes up.
Employee Stock Options and the IRS
Employee stock options are a bit more complicated than cash compensation, You don’t pay tax when the option is issued, but you do pay tax at the time that it is exercised.
The IRS puts employee stock options into two main categories. This being the IRS, each category has several different names, depending on who are you are talking to.
• Category One includes options known as statutory stock options, qualified stock options, employee stock purchase plan options, or incentive stock options. I’ll refer to these as incentive stock options in the rest of the article.
• Category Two consists of non-statutory options or non-qualified option. I’ll refer to these as non-qualified stock options in the rest of the article.
Incentive stock options are generally excluded from income when you receive them. You do not recognize any income when you exercise them, either – unless you are subject to the Alternative Minimum Tax. When you sell the stock purchased by the option’s exercise, then the amount is treated as a capital gain or loss in most situations.
Non-qualified options are treated as taxable income if there is a readily determined market value. In most cases, though, there is no market value, so there is not a taxable event until the option is exercised. When that happens, you have to include the fair market value of the stock received when the value is exercised, less the amount you had to pay.
All of the details are in IRS Publication 525, and you may need the help of a tax expert if you are exercising a lot of options.
When to Exercise
Options often expire worthless. This goes for exchange-traded options as well as employee stock options. Many companies issue incentive options that are based on stretch goals. Or, the price of the options may have been reasonable when the options were issued, but now the stock market is not cooperating. The options of a private company may have value only if the company is acquired or holds an initial public offering.
That’s why the general advice is that you should exercise your options when they are in the money, meaning that it is profitable for you to exercise them. If the purchase price set by the option is less than the price of the stock in the market at the date when you are allowed to exercise, you should exercise.
Because there are tax implications at the time of exercise, though, you should make sure that you are prepared to pay them when you exercise. For many people, this means you have to sell at least some of the stock as soon it is received. Some option holders choose to hang on to their options in the hope that the stock price will appreciate further, making the option more valuable while putting off the moment of reckoning with the IRS.