Definition
An Employee Stock Option (ESO) is a contract that grants employees the right to buy a specified number of shares of the company’s stock at a predetermined price, often referred to as the grant price or strike price. The fundamental purpose of ESOs is to align the interests of employees with those of shareholders, incentivizing employees to contribute to the company’s success.
There are two primary types of ESOs for tax purposes:
- Statutory Options: Also known as Incentive Stock Options (ISOs), these are tax-qualified options that provide favorable tax treatment under the Internal Revenue Code if certain conditions are met.
- Nonstatutory Options: Also known as Nonqualified Stock Options (NSOs), these do not qualify for special tax treatments and are taxed differently from ISOs, usually resulting in ordinary income tax at the time of exercise.
Examples
- Incentive Stock Options (ISOs): An employee is granted 1,000 ISOs at a strike price of $10 per share. The current market price at the time of grant is also $10. After two years, the stock price rises to $20 per share. The employee exercises the options, buying 1,000 shares at $10 each, despite the market price being $20. At exercise, there’s no immediate income tax due, but if the employee holds the shares for another year before selling, profits may qualify for capital gains tax treatment.
- Nonqualified Stock Options (NSOs): An employee receives 500 NSOs with a strike price of $15, while the current market price is also $15. After three years, the stock price climbs to $25 per share. The employee exercises the options, buying the shares at $15 each. The difference between the exercise price and the market price ($25 - $15 = $10) is counted as ordinary income, subject to income tax and payroll taxes.
Frequently Asked Questions
Why do companies offer Employee Stock Options?
Employee Stock Options (ESOs) are offered to motivate and retain employees. They serve as both an incentive for employees to work towards increasing the company’s stock value and a retention tool since options typically vest over a period of time.
What is the vesting period?
The vesting period is a specified time during which the employee must wait before they can exercise their stock options. This period is used to encourage employees to stay with the company.
How are ISOs and NSOs taxed differently?
ISOs generally receive favorable tax treatments such as deferring taxes until the shares are sold and potential qualification for capital gains tax, whereas NSOs result in ordinary income tax at the time of exercise.
Can employees lose their stock options?
Yes, if employees leave the company before their stock options vest or if the company’s stock price drops below the strike price, making the options worthless.
What happens to ESOs when an employee leaves the company?
Typically, employees must exercise their vested stock options within a certain period after leaving the company (usually 90 days). Unvested options are typically forfeited.
Related Terms
- Vesting: A process by which employees earn the right to exercise a given number of stock options over time.
- Strike Price (Grant Price): The fixed price at which employees can buy the company’s stock.
- Capital Gains Tax: A tax on the profit from the sale of property or an investment.
- Ordinary Income Tax: Tax on earnings such as wages, salaries, and dividends.
Online Resources
- Investopedia’s Guide to Employee Stock Options
- Internal Revenue Service (IRS) - Incentive Stock Options
- National Center for Employee Ownership (NCEO) - Stock Options
Suggested Books for Further Studies
- “Equity Compensation Strategies” by Alan G. Archer
- “Understanding Employee Stock Options” by William Seth
- “The Stock Option Book” by Bruce Brumberg and Alicia S. Gray
Fundamentals of Employee Stock Option: Finance Basics Quiz
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