Sorry for not getting back to you sooner. I've been busy at work. I’ve worked a several companies both here and in the bay area to gone through the entire gamut of stock options.
Raybarnes did an excellent job explaining stock options.
I'll try to add additional information to what he said, particularly
regarding taxes. If this gets too confusing, consult a CPA/tax accountant. BTW: I’m not a cpa, so please confirm everything with someone who is.
Basic:
Stock options are a benefit a company gives to employees. They are rights for employees to buy company stock in the future at a set price. In your wife's example, her company gave her the right to buy 1100 shares in the future at $26.35. The purpose of stock options is to persuade the employee to stick around and to worker harder to push the earnings and hence stock price above the options price. The price at which you can buy the shares is called the “exercise” price. It is largely determined by luck (IE the day you join the company, or the day you are granted the stock options), although you can slightly time things when you join a company that has seasonal stock price swings.
Now, generally you will have to wait before you can do use these stock options. This is called “vesting”. Typically, companies spell out how long you have to wait before you can exercise a portion of the stock options. Typically, a stock option grant vests over a 4 year period, with the first 25% of the share amount available after 1 year front the date your give the option, and then 25%/12 month to month for the remaining 4 years.NOTE: sometimes this is negotiable, depending on the size of the company and how important you are.So… If your wife’s company stock is currently trading at $125/share don’t go celebrating right now and go on a shopping spree, because chances are she has to wait at least 1 year before she can do anything with them…and a lot can happen in a year…Similarly, if the current stock price is less than $26.35, her options are currently worthless (AKA underwater), but don’t be bummed yet, because she can’t do anything with them until she vests. And even if she vests, companies typically give a few years before you HAVE to do something. Qualcomm for example gives a few years after you vest before you have to exercise the options (otherwise they disappear).
Tax Consequences:
As long as you don’t exercise the stock options, you don’t have tax consequences. The moment you decide to exercise a stock option and buy the company stock, your tax consequences depends on
A)the type of stock option
AND
B)whether you decide to hold on to the stock or sell it.
There are two types of stock options
Non-qualified Stock Options (NQ)
Incentive Stock Options: (ISO)
The tax consequences are different for the different type of options
1)Non Qualified are the easiest to understand.
Let’s use a hypothetical example.
*Let’s say your wife exercises her stock options 1/1/2008 at $26.35/shares and 10000 shares.
*The day she exercise (1/1/2008), the stock prices is $56.35/shares.
Regardless of whether she holds onto the stock or sells it right away, the difference between the fair market value the day she execised and the stock option price will be taxed at ordinary income and should appear on a W2.
That is $56350-26350= $30000 will be taxed as ordinary income.
Now, what happens thereafter depends on when she sells those 10000 shares.
1a) She sells the same day. Well, she has no other tax consequences. The $30000 is all taxed as ordinary income.
1b) She sells the 10000 shares at a later day, but before 1 year. The difference between the stock price the day she sells it and the stock price the day she exercised is taxed as either short term capital gain or loss.
1b1) Let’s say she sells the shares 11/1/2008, and the stock price is $66.35.Recall, the day she exercised her options, the stock price was $56.35. She would have a short term capital gain of ($66.35-$56.35)x10000 , or $10,000 would be taxed as short term capital gains, in addition to the $30,000 she was taxed as ordinary income. This is fair, because in reality, she made $40,000 total.
1b2)Let’s say she sells the shares 11/1/2007 and that day, the stock price is $46.35, below the $56.35 price the day she exercised.
**$30,000 will be taxed as ordinary income tax as before (56.35-26.35) x 10000= $30k .
**$10,000 will be short term capital loss (46.35-56.35)x10000= $10k short term capital loss. …. And here lies the issue. IRS limits the maximum capital loss you can take each year before you have to carry it over to the next year (I think its $3k). So while you have to pay taxes on $30k you really didn’t earn, you can use the $10k capital loss to only offset any other capital gains up to a total $3k of the short term loss that year. You have to carry over the remaining losses next year.
1c) She sells the 10000 shares after 1 year… You have to pay ordinary income taxes on $30k this year. Then you pay long term capital gain taxes or accrue long term capital losses successive years, similar to 1b1, 1b2. You’re being asked to pay ordinary income taxes up front, but any capital losses in the future are limited to the $3k limit before the remaining amount is carried over to following years.
2)Incentive Stock Options (ISO) are by far the most complicated, and a lot of people in the Dot Com got burned by AMT with them. Usually, mature companies don’t give out ISO anymore, but in case you run into them…
The key difference is that exercising ISO’s are not computed as part of regular income tax. BUT, ISO’s are used in AMT tax (alternative minimum tax). If you don’t know what AMT is, I suggest you read up on it.
Let’s use a hypothetical example.
*Let’s say your wife exercises herISO stock options 1/1/2008 at $26.35/shares and 10000 shares.
*The day she exercise (1/1/2008), the stock prices is $56.35/shares.
*Suppose she decides to hold onto the stock for a year.
While the difference between the market price the day she exercised and her option price x10000 shares (IE $30,000) isn’t subject to ordinary income tax, it WILL be used in computing AMT. AMT tax rates are very interesting…you should expect to pay AMT as large as 28% if the spread between your option price and the Fair Market Value of the stock the day you exercised is very large. (The maximum rate for the AMT is 28%, but the tax resulting from a single large item can be greater than that percentage because of the interaction of various features of the alternative minimum tax.)
The second consequence from the AMT adjustment is that some or all of your AMT liability will be eligible for use as a credit in future years. This credit can only be used in years when you don't pay AMT. It's called the AMT credit, but it reduces your regular tax, not your AMT. In the best case, the AMT credit will eventually permit you to recover all of the AMT you paid in the year you exercised your incentive stock option. When that happens, the only effect of the AMT was to make you pay tax sooner, not to make you pay more tax than you would have paid. But for various reasons you can't count on being able to recover all of the AMT in later years.
You can avoid this by doing a same day sell on ISO’s. If you do decide to hold on, you should really consult an accountant, because there are other gotchas related to AMT, that I don’t feel competent to explain here.
I speak particularly of AMT and ISO, because one of the startups I worked at in the bay area had precisely this issue. We were granted stock options at $30/share pre-ipo. The first day of trading, we closed at $307/share, and a lot of people decided to exercise 10-20k shares that day. Due to lockup of insider shares, they could not trade the first day(90 days, if my memory serves me), and chose to hold on longer than a year for favorable long term cap gains . But thefFollowing year, stock tanked to about $150/share..So a lot of people got screwed ,because they paid a lot of AMT the first year, but could not recover the capital losses (or I should say, they have lifetime capital loss carryover). It financially devastated a lot of people, because they couldnt pay the AMT tax bill.
One of the key lessons to learn if your sitting on a wad of in-the-money stock options is don't be greedy, and don't go for that long term cap gains. It might not work to your advantage.
There are other things you want to manage as well, when you are heavily invested in the company you work for. Namely, watch out for have stock options, holding onto ESPP shares, buying company shares in 401k plans, and buying company stock in personal accounts all at the same time. A lot of enron/worldcon/CFC people I'm sure did this, and pissed everything away, and on top of that lost their job. Don't be greedy is the lesson.
Lastly, if you have in-the money stock options that are worth a lot but you haven't fully vested and are afraid that by the time you can vest, you company's stock might be worthless, I would consider hedging the stock options the company grants you buy buying short term put options, provided company policy doesn't forbid you in trading derivatives. Then, the only things that can happen to screw you is if you get dismissed before vesting.
