Stock Options Defined And Explained For Beginners

It’s common for businesses to offer benefits to lure employees to their companies. These benefits may include group health insurance, tuition reimbursement and moving bonuses. A less common employee benefit, especially outside of the startup world, is stock options.

If you’re offered stock options as a benefit, you might not understand all the details. But don’t worry, we’ll cover what they are, how they work and more in this beginner’s guide.

What Are Stock Options?

Stock options are contracts that give you the opportunity to purchase a company’s stock at a set price by a certain date. Buying options are a way for investors to profit from a stock going up or down in the future.

It’s a bit more complicated than simply buying a stock at its current market price and holding it or selling for a gain or loss. With stock options, buying the stock isn’t required – executing the contract is your choice.

Types Of Stock Options

When offering you stock options, the employer may present different types. Two of the most common employee stock options are nonqualified stock options and incentive stock options. These options have different restrictions, and the IRS taxes them differently based on certain rules.

Employee Stock Options (ESOs)

Employee stock options are often granted to a company’s employees, contractors or investors. They differ from privately purchased options in that the company sets the terms of the contract. On the open market, an individual can purchase an options contract and set their own terms. They can even bet that the price will go down, which isn’t possible with an employee stock option

To whom a company can grant stock options depends on the type granted. Nonqualified stock options and incentive stock options are two of the most common kinds. The former has fewer rules attached to it; the latter restrict who the company can grant stock options to.

Nonqualified Stock Options (NQSOs)

Nonqualified stock options can be issued to employees, contractors or anyone else the company decides to give stock options to. Since this option has fewer rules associated with it, it’s more common than incentive stock options.

But it’s also the option that is more likely to trigger a taxable event. Normally, you’ll have to pay taxes only when you sell a stock, but this isn’t the case with this option.

You might be responsible for paying income taxes under the following three scenarios:

1. Employee grants you nonqualified stock: If the market value of your nonqualified stock option can be “readily determined,” you have to report the difference between it and the value of your option as income. The amount will be taxed as ordinary income. If the market value isn’t available, you won't be responsible for paying taxes on the granted amount, according to the IRS.
2. You exercise your option: If you decide to purchase the option at the set price listed in the options contract, you’ll have to pay the difference between its value and the market price.
3. You sell your options: When you sell the stock you purchased, you’ll be responsible for paying capital gain taxes or reporting a loss when you file your taxes.

Incentive Stock Options (ISOs)

Incentive stock options are options that can only be granted to a company’s employees. They are usually given to executives or other highly valued employees. Unlike nonqualified stock options, you usually don’t have to pay taxes when you’re granted the option or when you exercise the right to purchase the stock.

Also, the amount of taxes you pay is taxed at the long-term capital gains rate – the rate investors are taxed at if they hold an investment for a year or longer. Depending on your tax bracket, this could be a more favorable rate than your ordinary income tax. For example, if your income is less than $80,000 some of your income might be taxed at 0%.

However, if you purchased the stock and held it for less than a year, you’d be responsible for paying short-term capital gains taxes. This means the amount you pay in taxes would be based on your ordinary income tax rate.

How Do Stock Options Work?

Now that we’ve covered what stock options are and the different types, let’s dive into how they work. Imagine for a second that a woman named Kayla has just started working for a tech company called To the Moon Enterprises. In addition to a high-paying salary, the company offers her employee stock options.

Let’s take a look at some of the terms she encounters and how the process works.

Issue date: The company lists her start date as the issue date.

Strike price: While reading the contract, she sees that the company agrees to let her buy 1,000 shares of its stock at $10 per share. This is referred to as the strike or “exercise” price. 

Vesting: Kayla thinks to herself that it would be cool to sell the shares on the market her first week on the job. However, she notices a section called vesting that prevents her from doing so. The vesting section states, “For every year on the job, you have a right to exercise 25% of your stock options.”

This means she won’t be able to sell any shares until her first year is up. Then she’ll have the option to buy 250 shares. After year 4, she’ll be fully vested, which means she can choose to buy 100% or 1,000 shares.

Expiration date: After reading some more, she sees that the option to buy the company’s stock at the strike price will expire after 10 years. Once the expiration date passes, she’ll have to purchase the stock at market price, if it’s available.

Market price: Just for fun, she opens the investment app on her phone to see how the stock is currently performing. To her surprise, it has a market price of $30. If she could buy and sell the stock now, she calculated that she’d have a $20,000 gain (market value minus purchase price).

Call options: Kayla has heard the term “call options” before, but isn’t quite sure how it relates to her employee stock options. After doing some quick research, she learns that a call option gives her the right to purchase a stock at a certain price, but she doesn’t have to exercise the option.

Contracts: Unlike the private market, Kayla doesn’t have to pay her employer any money for the right to purchase the shares. If she were purchasing options outside of her employment, she might purchase option contracts. These contracts would give her the right to buy or sell a stock at a set price.

Premium: If Kayla wanted to purchase option contracts, the amount of money she purchased them for would be considered the premium.

Considerations Before Accepting Stock Options

If you’re being granted employee stock options, make sure you understand the tax implications, exercise options and what impact leaving the company may have.

Tax Considerations

First, make sure to understand what type of employee stock option is being offered. Based on our discussion above, the tax consequences will be different based on whether the company offers you nonqualified stock options versus incentive stock options.

It may be a good idea to reach out to a tax advisor to discuss the pros and cons.

Exercise Options

If you were to exercise your options, how would you go about doing so? Ask your employer how this process would work. Another good question to ask is how to find the market value of those shares, if the company is public. That way, you’ll get a good idea of how much of a discount you’re truly getting by purchasing the share through the employer.

Terms After Employment Has Ended

Another thing to consider is what will happen to the vested portion of your stock options when you leave. Will the answer be different based on you retiring or getting fired? Ask your employer these questions before accepting employee stock options.

The Bottom Line

Being granted stock options by an employer can be a wonderful incentive. If you’re able to buy the stock at low price and resell it for a higher price, you might be able to pocket a decent chunk of change in the future.

However, since you can’t know for sure if the stock will rise, counting on your employee stock options is risky. It also comes with tax consequences that are different based on the type of employee stock options you’re offered. On top of that, the vesting schedule may only allow you to purchase a certain amount of shares each year.

If you’re not sure how to respond to being granted employee stock options, speak to a financial advisor. They should be able to walk you through the pros and cons of receiving the options, based on your unique financial situation. Be sure to bring a copy of your stock options agreement, so they can review it with you.