Employee stock options & how they work
Stock options can incentivize employees to work toward increasing the company’s stock value, aligning their interests with those of the shareholders.
It used to be that stock options were only offered to top management and particular key employees to tie their interests in with those of the company. Over time however, employers began to consider all their employees to be key assets to the company, so the number of people holding stock options has increased significantly.
WHAT ARE EMPLOYEE STOCK OPTIONS?
An employee stock option (ESO) is a benefit offered by companies to their employees, giving them the right to buy a certain number of shares of the company’s stock at a predetermined price, known as the exercise or strike price, after a specific period.
BENEFITS OF EMPLOYEE STOCK OPTIONS
Employee stock options incentivize employees by aligning their interest with company performance, promoting retention, and attracting talent. They offer potential financial rewards if the company’s stock price rises, fostering a sense of ownership and motivation to contribute to the company’s growth and success.
WHAT ARE THE TYPES OF EMPLOYEE STOCK OPTIONS?
There are two classifications of stock options that are issued in this manner: non-qualified stock options (NSO) and incentive stock options (ISO).
NON-QUALIFIED STOCKS Vs. INCENTIVE STOCK OPTIONS
Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs) are two types of employee stock options with different tax treatments and eligibility requirements:
NON-QUALIFIED STOCK OPTIONS (NSOs)
Eligibility: Can be granted to employees, directors, contractors and others
Taxation:
o At Exercise: The difference between the exercise price and the market price at the time of exercise is taxed as ordinary income.
o At Sale: Any additional gain or loss after exercise is taxes as a capital gain or loss.
Regulations: Fewer restrictions compared to ISOs.
INCENTIVE STOCK OPTIONS (ISOs)
Eligibility: Can only be granted to employees
Taxation:
o At Exercise: No immediate ordinary income tax; however, the difference between the exercise price and the market price at exercise may trigger the Alternative Minimum Tax (AMT).
o At Sale: If holding requirements are met (two years from grant date and one year from exercise date), the entire gain is taxes as a long-term capital gain. If not, its taxed as ordinary income.
Regulations: Must adhere to specific IRS requirements, including holding periods and limits on the value of ISOs that can first become exercisable in a year (typically $100,000).
KEY DIFFERENCES
Tax Treatment: NSOs are subject to ordinary income tax upon exercise, whereas ISOs may offer more favourable tax treatment if holding requirement are met.
Eligibility: NSOs can be granted to a wider range of recipients, while ISOs are restricted to employees.
Regulations: ISOs have stricter regulatory requirements compared to NSOs.
CONSIDERING EMPLOYEE STOCK OPTIONS FOR YOUR EMPLOYEES?
If you are thinking about employee stock options for your organization, please bear in mind the information provided above is not a fully comprehensive answer. We strongly advise that you consult a tax advisor before making any final decisions about your company’s employee stock options.
Our payroll tax specialists would be delighted to speak with you if you have any questions.
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