To motivate employees, a business might provide equity compensation in the form of options. This is a sort of investment that permits the legal holder of the stock to acquire a certain number of shares of the company’s stock at a discount. Employees may accept this offer and retain the options until vesting. The employee can then be compensated for transferring ownership of these shares. This results in profits associated with the selling. Companies make this financial investment as a means of enhancing employee retention. Employers utilize stock grants and stock options to reward and encourage their employees.
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Stock grants are designed to retain employees for a predetermined time period. An employee grant is another name for a stock grant. This would be the case if a corporation granted a new employee 50 shares of stock that vest over a two-year period. This means the employee will only receive this stock after two years of employment. If the employee leaves the business before this two-year term expires, they will forfeit this stock. Due to the design of a stock grant, it serves as effective retention of employees.
What Is A Stock Option?
For stock options to function, a corporation grants employees a certain number of options with a time restriction and a specified price. The employee can purchase this allotted number of stocks at the company-specified price within a preset time limit. Typically, the price at which these employees acquire stock options is below the current market value. The employee receives a bonus equal to the difference between what they paid for the stock options and the stock’s current market value.
Varieties of Stock Option
There are two types of stock options: incentive stock options (ISOs) and nonqualified stock options (NQSOs) (NSOs). The key distinction between the two sorts is how taxed you will be.
When you are awarded ISOs, there are no tax repercussions because no property is transferred on the grant date. For options to qualify as ISOs, they must have a grant price equal to or greater than the stock’s price on the day of grant and a period of 10 years or less.
The grant price becomes the cost basis for any shares obtained via ISO exercise. When you sell these shares, the difference between the selling price and your cost basis (usually the grant price) is the taxable income you must account for. As explained in the next section, the timing of your sale or transfer of these shares is crucial for determining your tax liability.
Although the exercise of ISOs does not produce a taxable event, there may still be tax repercussions. The taxable spread is the difference between the stock price on the day of exercise and your option cost. If you elect to retain the shares acquired through an ISO exercise, the taxable spread will become a preference item for payroll tax (AMT) purposes in the exercise year.
When selling stock acquired through ISO exercises, the timing of the sale is crucial. So long as you’ve kept the stock for the appropriate holding period — at least one year from the date of exercise and two years from the date of the grant — the difference between the selling price and your cost basis will be taxed as a long-term capital gain. The larger the difference between your marginal tax rate and the long-term capital gains tax rate, the more appealing an ISO becomes.
You will not qualify for long-term capital gains tax treatment if you fail to hold the stock for the requisite time (as stated above). The term for this is “disqualifying disposition.”
If you “disqualify” any ISO shares, you will be taxed identically to nonqualified stock options, as described in the next section. The taxable spread established by exercising options (stock price minus grant price) will be taxed as ordinary income at marginal tax rates. If the stock has increased in value since the date of exercise, the increase will be taxed as a short-term capital gain. The table on the next page compares the tax treatment of ISOs satisfying the holding period against those sold in disqualifying disposal.
NSOs are the most prevalent form of options granted by enterprises. As with ISOs, there is no taxable event when NSOs are given. When exercising NSOs, a taxable event occurs, unlike when exercising ISOs. This tax applies regardless of whether you sell the generated shares immediately or continue to keep them.
When an NSO is exercised, ordinary income equal to the taxable spread must be recognized (the stock’s price on the day of exercise is less than the option grant price). This income is considered compensation and will be reported on Form W-2. This compensation will be subject to both income and payroll taxes. Once NSOs are exercised, the cost basis of the new shares will match the stock’s closing price on the day of exercise. If you choose to retain the shares after exercising the option, this cost basis will be essential for calculating future profits or losses when you finally sell the stock.
When you sell the shares, you will record a capital gain or loss equal to the difference between your cost basis (the stock price at the time of exercise) and the selling price. The capital gain or loss will be considered short-term within one year of the exercise. You will incur a long-term capital gain or loss if you sell the shares more than a year after the exercise date.
The benefits of stock grants
Stock grants are structured such that they constitute equitable property. As a result, these stock grants have inherent worth. When the stock market is deemed volatile, it is common knowledge that stock options become less valuable than a company’s employee cost. This renders stock options appear to be worthless. As the employees of a business have not acquired these stocks altogether, stock grants are able to maintain a certain value over time.
In addition, some employees who are offered stock option incentives are not advised that they must take action to get the stock. Consequently, employees seldom utilize this chance and get stock options. The design of stock grants eliminates this error by directly awarding the stock to the employee.
The benefits of stock options
Stock options are designed to increase the value for employees who receive them. An illustration of this would be if an employee is given the opportunity to purchase a share of stock for $7 a share, and the stock’s value suddenly climbs. The employee can purchase additional shares at the option price, increasing their stock-based earnings.
In addition, stock options offer greater flexibility than stock grants. This is because these options have an early exercise option. Consequently, an employee can exercise his options if he intends to leave the organization, and this is possible prior to the conclusion of the vesting term. Thus, the employee is able to reap the advantages of the stock without having to continue working for the firm.
How Does A Stock Option Grant Work?
These options allow employees to acquire shares of a firm at a price below the current market price per share. Employees who take advantage of this chance and acquire these shares at a price below the market price and then sell them when the company’s stock is trading much higher might earn a substantial profit. This is because these employees can sell the stock when the price of the stock rises. Thus providing both long-term and short-term capital gains.
Similarities between Stock Options and Stock Grants
Both stock options and grants are intended to inspire the employee to stay at work longer, perform more, and contribute to the appreciation of the company’s stock. It is to the employee’s advantage, as the employee stands to gain more the more valuable the company’s shares are. As vesting is often contingent upon continuing employment, both kinds of compensation discourage the employee from resigning before the stock or option grants vest.
Stock or option grants also enable employers to postpone a portion of compensation. Typically, no cash is required until the stock or option vests, which is a big benefit for developing companies. Another benefit is that stock grants and options cost the stock more when the stock price is high and less when it is low. Because the entire value of an options package and a stock grant is dependent on the stock price. Thus, the employer’s payment responsibilities reflect its financial performance.
How do stock options and stock grants differ?
Options are a hazardous investment; they offer more potential profits, but in the event of a loss, they may be worthless. A stock option permitting the holder to purchase each share at $12 has no stock if the market price is $12, $1 when the stock price hits $13, and $2 when it reaches $14. In other words, little fluctuations in the stock price might have a significant impact on the entire value of the package. However, the net worth of a stock grant is far more solid and will not go to zero unless the business ceases operations. In order to balance the risk and reward profile of the compensation package, the employer may grant options and stock.
When And How Do Your Stock Grants Become Vested?
As stated previously, the sort of stock grant you get might affect when your stock grants become your property. Vesting is the period between receiving stock grants and actually being able to do something with such grants.
Prior to the vesting of your stock grants, they are only a future promise that you cannot now act on. Your boss has a strong motive to make this future promise, as they can use it to both reward you for the company’s success and retain the golden handcuffs on you.
Consider the following: you have 10,000 restricted stock units that vest in three years. Let’s say that the current share price on the market is $25.
In 3 years, when the shares vest (assuming no change in market price), your shares will be worth $250,000 ($25 per share multiplied by 10,000 shares).
If you leave the company before the vesting of the shares, you will forfeit your entitlement to the unvested shares, departing with nothing and intentionally waiving the right to a $250,000 future guarantee.
This promise (or, more precisely, this desire) is what makes many employees believe it is worthwhile to remain with a firm that offers stock grants, even if a better opportunity exists elsewhere.
Vesting can occur in a variety of ways, but it typically takes place over several years. For instance, you can vest shares at a rate of 25% per year for four years commencing one year after the shares are awarded.
Get a copy of the plan paperwork to discover your specific vesting timetable. A plan document specifies the regulations applicable to your stock grant.
Why Should You Accept Your Stock Grant Constantly?
It can offer substantial financial rewards.
When a corporation gives equity, they provide you with a financial incentive to remain committed to the business, as you stand to profit from its success.
The defining characteristic of stock options and grants is that they give optionality. A stock option is not the same as being granted shares outright, but it allows you to acquire shares of common stock at a predetermined price. You might realize big financial benefits if the stock price rises, but only if you’ve exercised (bought) your options. This is only possible if you have accepted your grant.
The sooner you comprehend your options and the monetary consequences of exercising, the sooner you can make prudent financial judgments. Timing is crucial, and allowing yourself additional time to exercise your stock options might be the difference between a financial gain and forfeiting all advantages.
It is free, and you are not required to buy your options.
Even though you accepted your stock grant, you are not required to acquire your shares. You are not entering into a financial contract; rather, you are committing to having the option to acquire stock in the future. To accept your stock grant, all you need to do is sign on the dotted line.
In general, there are no repercussions associated with accepting your offer. The only exception is if you are awarded an RSU grant. Upon vesting, RSUs may have a taxable gain, meaning you may be required to pay tax on them. Though the tax isn’t ideal, firms often enable you to sell shares to cover it, and since RSUs typically don’t vest until an IPO or acquisition, you’ll typically have the cash on hand to cover the tax.
How And When Do You Tax Your Employee Stock Grants?
When receiving employee stock grants as part of a compensation package, it is essential to examine the tax ramifications of the grants. Not understanding the unique tax regulations for each type might cause you to make significant mistakes that result in you paying more in taxes than you should.
Let’s examine many important forms of stock grants and when they are taxed:
Restricted Stock Units — In the majority of instances, restricted stock units are taxed upon vesting. The whole value of the shares as of the vesting date is subject to taxation.
Nonqualified Stock Options — In general, NSOs are taxed when the shares are exercised and not when they vest. This allows you to decide when to deal with the impending tax burden.
Incentive Stock Options – When you exercise an incentive stock option, you are often taxed, and Additionally, you are taxed when the shares are finally sold. Alternative minimum tax (AMT), AMT credit, long-term capital gains, and qualifying holding periods comprise the exact taxation of ISOs.
Plans for Employee Stock Purchase – You are generally taxed when you sell your ESPP shares. You must pay tax on the discount you obtained as well as any profit over the date of purchase. How you are taxed depends on the length of time you have owned the stock.
If you are aware of the sort of stock grant you have, you may begin tax preparation. And while tax should not be the sole issue in deciding when and how to use your stock grants, it should be a significant one.
In reality, income tax may significantly affect the amount you get after taxes on the sale of your stock grants. This selection may affect the proportion of your net worth that is invested in concentrated stock positions.
When it comes to employee retention and executive compensation, stock grants, and stock options are more commonly utilized than cash. Incentive stock options are so crucial to a business.