When to Exercise Your Stock Options
"Deciding when to exercise your option can be a complex decision. Therefore, it
is important to know the rules before you decide to cash in your options."
by Alan L. Olsen, CPA, MBA (tax)
Greenstein Rogoff Olsen & Co. LLP
Know the Rules
Employee stock options can provide you with a substantial source of deferred income
and permit you to control the recognition of taxable income. You generally pay no
tax when an option is granted because you are not receiving any shares of
stock, only the option to purchase shares at a later date.
In general, holding an option to acquire stock may be better than holding the stock
itself. The option provides protection against loss should the value of the stock
decline below the exercise price. In addition, the option gives the holder equivalent
ownership rights in the corporation, without requiring any immediate investment.
Employee stock options offer the potential to have post-exercise stock growth taxed
as capital gains rather than ordinary income. This provides an advantage for those
who are in the top tax brackets
Know the Difference
Nonqualified Stock Options (NSOs) give an employee the option to buy corporate
stock at a specified, fixed price (usually at fair market value at the time the
option is granted). In general, you must exercise your option to buy within a specified
time period--typically 10 years or less.
Upon exercising your rights, any gain realized from the spread (the difference
between the exercise price and the fair market value) is taxed as ordinary income.
However, any gain realized from the date the option exercised until the date the
stock is sold is taxed as capital gain.
Incentive Stock Options (ISOs) also offer the option to purchase corporate
stock at a set price, but ISOs cannot be issued with an exercise price below
the current fair market value of the stock.
Generally, the spread on ISOs is not subject to ordinary income tax at the
time you exercise the option. However, spreads may be subject to the alternative
minimum tax (consult your GROCO financial adviser for more information). Gain realized
upon the sale of the ISO stock may be taxed as capital gain. Provided you have held
the ISO stock for at least one year from the date of exercise and at least two years
from the date the option was granted, the entire gain recognized upon sale of the
stock is taxed as a long-term capital gain.
When to Exercise Your Options
The decision of when to exercise your options depends on several factors
as well as your particular situation:
Your Company's Plan
Generally, options become exercisable over a period of years. For example, options
granted in the company plan vest 20 percent a year over five years. It's important
to know the details of your firm's plan before you make a decision.
Your Company's Growth
Understanding how your company is poised for growth is another important factor
in your decision making process. Issues to review and understand are:
- How your company makes money – understand the industry that their earnings are tied
- Evaluate sales – compare your company’s sales to the industry average of competitors.
- Industry trends – monitor the industry that your company operates in. Look for growth
opportunities and understand your company’s strategy for capturing market share.
- Understand the factors that can affect the liquidity of the market – are lower interest
rates and tax cuts freeing up resources for the company’s growth plans?
- How your company is financing growth – are they growing as expected?
- Know your leaders and their track record – a company’s strong executive team will
likely yield continued success.
- Understand your company’s P/E (price to earnings) ratio – look for strong cash flow
and well-managed costs.
Finally, the way to make great returns in the market is by investing in great companies
and then holding the stock for the long term.
Your Current Financial Needs
The decision to exercise should consider the need for cash, the proximity to the
option's expiration and/or the current stock value as compared to its expected future
value. With regard to ISOs, because of taxes, the required holding periods should
be considered when determining when to exercise the options and/or sell the underlying
Balancing Your Portfolio
You may also choose to exercise an option if your company's stock represents a large
portion of your investment portfolio and you wish to diversify your holdings. Some
professionals say to reduce investment risk, company stock should not represent
more than 40 percent of your portfolio.
Obviously, market conditions will play a large role in your decision to exercise
your option. If the stock underlying the option appreciates, you may wish to hold
on to options as long as possible in order to take advantage of future gains.
In the case of NSOs, you may want to consider exercising your option over a few
years to avoid being forced into a higher tax bracket. Remember, the spread on NSOs
is subject to regular income tax at the time of exercise. Because appreciation occurring
before exercise is taxed as ordinary income, it may be advantageous to exercise
Your company's nonqualified stock options may be transferable to family members.
If so, you may be able to trim your estate tax by giving options to your heirs.
The transfer may be gift tax free if the value transferred is $11,000 or less ($22,000
if married). notwithstanding the transfer, upon exercise the executive will be responsible
for any income taxes generated.
This page is intended to provide a general guide to the subject matter and should
not be regarded as a basis for ascertaining the liability to tax in specific circumstances.
In such instances, separate analysis and advice should be taken. Although all reasonable
care has been taken in the preparation of this manual, Greenstein, Rogoff, Olsen
& Company, LLP cannot be held responsible for any errors it may contain, or
any consequences sustained by any person who relies on it. We advise you to
consult professionals before taking further action. We will be pleased to assist
you with detailed planning.