We recommend Internet Explorer set to 1024x768.

© 2005 Brian F. Schreurs
Even we have a disclaimer.

This exercise is going to focus on incentive stock options (ISOs), the better of the two types of stock options (as opposed to non-qualifying stock options). ISOs are great for employees because, unlike non-qualifying stock options, they are only taxable when the employee sells the shares. Non-qualifying stock options are taxable at both purchase and sale.

A stock option is a situation where an employer grants an employee a privilege to purchase company stock at a set price -- typically a landmark such as the date of the option plan approval, or the date of hire for an employee. This set price remains unchanging over time, even as the actual market value of the stock fluctuates. If the market price of the stock drops below the value of the option, then the option is worthless. But if, over time, the market price of the stock rises above the value of the option, then the stock options are worth the difference between the option price and the market price, times the number of shares in the option. For example:

Sunshine Corp. offers employees a stock option of 2,000 shares each at an option price of $18.00 per share. Over time, the market value of the shares appreciates to $25.00 per share. The stock option is now worth $14,000.

(market price x #shares) - (option price x #shares) = value
(25.00x2000)-(18.00x2000)=14,000

"Over time" is important. Most stock options come with a vesting schedule. Vesting is simply a time delay from when the company offers the option to when the employee can actually use it. The intent is to encourage employee longevity to wait out the vesting period rather than simply cashing out at first opportunity. It doesn't cost anything; it's just a waiting period. The options are vested to the employee once the vesting period is over.

But having vested options does not mean that the employee is forced to purchase right away. An employee can continue to hold the options without buying up to the expiration date of the options -- usually some distant date, or triggered by an event such as quitting the job. A typical scenario might be a stock option that vests 25% each year for four years from award, then expires at the tenth year. Most employees, however, are going to want to buy the options sooner or later after they are vested, assuming the stock has been going up.

The easiest way to buy the stock options is to pony up the cash and just buy them. In the Sunshine Corp. scenario, the employee would need $36,000 to buy the options -- $18 a share option price times 2,000 shares. But the newly purchased shares would be immediately worth $50,000, so the employee would make an immediate $14,000 paper profit. The beauty of an ISO is that this $14,000 profit is not taxable at the time of the purchase, provided that the employee retains the shares for at least one year (actually, one year from the date of purchase and two years from the date the options were offered, but it's an irrelevant distinction for most people). The employee only pays taxes when the shares are sold, and if it's been more than a year, then the taxes are levied as capital gains rather than regular income. This is a much lower tax bracket for most people: 15% instead of 39%, for example. If the employee were to use cash to immediately buy and then sell all shares, or actually sell all shares at any time within the first year, then the sale counts as regular income and the employee has to pay the full taxes on it -- in this case, $5,460 instead of $2,100.

Of course, who among us actually has $36,000 lying around to buy up all this stock?

Companies recognize this and many have in place a cashless exercise plan. Under this plan, a broker lends the employee enough money to buy all the shares, then the broker sells enough shares to pay for the initial loan plus taxes due. It is then up to the employee to decide whether to hold the remainder of the shares or sell them as well.

But wait: taxes? Yes, unfortunately, using the cashless exercise, those shares that have to be sold to pay for the transaction become taxable as regular income. It's unavoidable for us blokes who don't have a spare 36 grand handy. The decision really is between whether to cash out all the shares or hold what you can and cash only those necessary. Let's take a look with the Sunshine Corp. scenario.

First, the employee must know how much it will cost to buy the shares:

option price x #shares = purchase cost
18.00x2000=36,000

Then, the employee must know how many shares it will take at the market price to cover the purchase cost:

purchase cost / market price = #shares
36,000/25.00=1,440

The employee will have to sell 1,440 shares to pay for the loan that made the purchase. But doing so creates a tax liability because the shares were held for less than a year. To figure the taxes, the employee needs to calculate the gain on the sold shares:

(market price x #shares) - (option price x #shares) = taxable profit
(25.00x1440)-(18.00x1440)=10,080

This taxable profit will be taxed at the regular income rate, not the capital gains rate, so figure approximately $3,930 due to Uncle Sam. The employee can pay this out of pocket (not likely) or sacrifice more shares to cover it:

taxes due / market price = #shares
3930/25.00=157.2

Most of the time it's not possible to sell a partial share, so it'll have to be rounded up to 158.

So what does the employee have left? The employee started with 2,000 shares, then gave up 1,440 of them to pay for the brokerage, and another 158 to pay taxes. That leaves 402 shares, at $25.00 per share, for a profit of $10,050. If the employee sells these last shares immediately to cash out, then Uncle Sam will take another $3,920 in regular income tax for a net profit of $6,130. If the employee waits a year before selling the last shares, then the profit will be taxed as capital gains and will net $8,542 after $1,508 in taxes -- assuming the market value stays the same. If the value of the shares continues to increase, then this figure would go up as well. And if the employee continues to hold the shares beyond the first year without selling them, then they will continue to increase in value as the company stock increases in value, with no taxes due at all until the day the employee finally decides to sell. Advantage: buy and hold.

The next decision the buy-and-hold employee will have to face is whether to buy the shares early or late. This scenario will assume that the employee is deciding between buying in when the shares are fully vested at five years, or holding out to the last minute before expiration at 10 years, and also will assume that the company stock generally trends upward across the entire timespan. Obviously, if the stock is a loser at the five-year mark, the employee doesn't want to buy at that time. Let's also assume that Sunshine Corp.'s option price is $18.00; the five-year market price is $25.00; and the ten-year market price is $32.00.

We already know that if the employee buys in at five years and $25.00 per share market price, the net result will be 402 shares worth $10,050. Over the next five years these will increase in value to the $32.00 per share market price, for a net value of $12,864. The employee has, up to this point, shown a taxable income of $10,080 and paid $3,930 in taxes. The paper gains since the transaction at five years are thus far not taxable.

If the employee were to hold off until the tenth year to buy...

Cost to buy the shares:

option price x #shares = purchase cost
18.00x2000=36,000

Number of shares to sell to cover purchase cost:

purchase cost / market price = #shares
36,000/32.00=1,125

Taxable profit on sold shares:

(market price x #shares) - (option price x #shares) = taxable profit
(32.00x1125)-(18.00x1125)=15,750

Taxes due: $6,143

Number of shares to sell to cover taxes:

taxes due / market price = #shares
6143/32.00=192

Number of shares remaining:

total shares - sold for purchase - sold for taxes = #shares
2000-1125-192=683

Value of stock option remaining:

#shares x market price = value
683x32.00=21,856

Advantage (BIG advantage): buy and hold just before the options expire. The secret is that, despite paying more in taxes to purchase the option, at the end of the day the employee had more shares left over with the ten-year plan than with the five-year plan. More shares is the way to go as long as the stock is increasing in value. (The lucky bugger who had $36,000 in cash on hand to buy the shares without a brokerage loan -- that employee would see a cool profit of $28,000 if he bought at $32.00 a share!)

There is one trouble spot in the tax code, though -- buying into an ISO may put a higher-income individual into the alternative minimum tax bracket, if only for a year. For AMT purposes, all profit from the transaction is treated as regular income, which may create a higher tax liability for that year. So much higher that it's worth buying in early and sacrificing the profit? Hard to say. It depends on other household income, among other things. For those employees where AMT may be a concern, it would probably be best to consult a tax expert to determine whether the employee would be facing AMT and what the liability might be.

AMT woes aside, though, clearly the most profitable course of action with an ISO is to buy and hold just before it expires. Cashing out as soon as the options vest is potentially throwing away thousands of dollars.