Stock Options: What You Need to Know about Vesting, Holding, Salary and Taxes

So your employer offers stock options as a part of your salary package. What does that mean?

Companies offer stock options for two basic reasons:

  1. To add heft to a salary offer (or annual bonus) when actual cash is in short supply. This is a favored tactic of start-ups that need to attract talent without spending much money.
  2. To help employees feel more invested in the company, and therefore theoretically more willing to work harder, give up their personal lives, etc.

But what does this largesse mean for you? Before you can value the stock options you've earned, you need to understand what they are, and just as importantly, when you can convert them to actual cash.

Options Are Not Stock

With a stock option, you've been granted the right to buy stock. Usually you'll have to wait a period of years before the options vest. Once they vest, you still may face restrictions on when you can exercise the options and cash out. Some firms require additional waiting periods, while others will let you cash out the options only when you leave the firm. While you're waiting, in theory, you're working hard to make the company grow, so your options increase in value.

In addition to stock options, a company may offer an employee stock purchase plan, a very different animal. A purchase plan offers a chance to own company stock immediately, and may include an employee discount on the stock price.

With a stock purchase, you become an owner in the company. Stock options, however, only give you the right to become an owner at a certain date. You are never obligated to exercise your options.

How to Value Stock Options

When you receive a stock option, it is usually valued at the current market price (although the company may offer a discount on the price). You may see this referred to as the strike price or grant price.

As you wait for your options to vest, you hope for the stock price to rise. As the price goes up, the value of your options increase, since you can buy the stock at the grant price. The selling price represents the final value of your option, since it will determine both your profit (and in a sense your true salary for all the years of vesting and holding stock), and your tax obligations related to the options.

Tax Facts

Your company gives you stock options instead of salary. What does the IRS think. Actually the U.S. tax code is pretty lenient when it comes to options. If the company has minded its P's & Q's when putting the offer together, you'll receive "qualified" or "statutory" stock options. You don't have to declare the options on your tax returns.

To avoid extra tax burdens, you'll need to hold your options for at least two years after the grant, and at least one year after selling it. If you do, you'll be subject to the capital gains tax, but won't have to declare the options as income. If you sell before the mandated period, though, you may have to declare the value of the sale as income, and also pay the alternative minimum tax.

Congress has taken some steps to relieve the burden on employees when this happens, but the laws have become quite complicated. Be sure to consult with a tax advisor on the best strategy for selling and declaring your stock option proceeds.

When -- and If -- to exercise your options

You've become vested in your options, and have the right to sell (company documents may call this divesting). What now? The decision can rest on several factors: