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Stock Option Exercise

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Stock option exercise is the process by which the holder of a stock option contract chooses to buy or sell the underlying shares at a pre-decided price. An employee chooses to exercise their right to buy the underlying shares of a company at a predetermined price while exercising their stock options. The process typically involves notifying the employer or broker and providing the necessary information to facilitate the exercise, such as the number of options exercised and the desired payment method. This blog looks into several aspects of the stock option exercise.

Types of Employee Stock Options

Employee stock options are primarily of two types, namely: qualified options and non-qualified options. These terms reflect whether the options meet specific tax and legal criteria. Both of these stock options are explained further.

Non-Qualified Stock Options

Non-qualified stock options are the most common type of stock options, also known as non-statutory stock options. When these options are exercised, the profit is treated as regular income for tax purposes. For instance, if the strike price is $100 and the market value is $150 at exercise, the $50 difference per share is considered the bargain element and subject to ordinary income tax. Typically, the company withholds taxes on the bargain element on behalf of the employee. The exercise date becomes the acquisition date of the stock, and its fair market value becomes the purchase price and cost basis. Any gain or loss on shares held for over a year is considered long-term and is usually taxed at preferential rates. But if the shares are held for less than a year, the gain or loss is incurred in the short term and is accordingly taxed at the individual’s marginal tax bracket. Consider an employee in the 35% tax bracket who exercises options when the stock is valued at $150. They would be required to pay a short-term capital gains tax of 35% on the $10 profit per share if they sold the shares six months later for $160. They would pay a long-term capital gains tax of 20% on the $25 profit per share if sold one year and one week later at $175 a share.

Qualified Stock Options

Incentive stock options, also known as qualified or statutory stock options, have more favorable tax treatment but stricter requirements. The bargain element of exercised ISOs is not considered regular income but is factored into Alternative Minimum Tax (AMT) calculations. Depending on the size of the bargain element, exercising ISOs can trigger AMT in the current year, with a maximum marginal rate of 28%.

Viable Situations for Stock Option Exercise

  • Private companies often have policies that delay the ability to exercise stock options immediately. This usually involves a requirement to continue working for a specific period (often 1 year) or achieve certain milestones, known as a cliff period.
  • The process of acquiring the privilege to exercise stock options is known as vesting; generally, only vested stock options can be exercised. Once you reach the vesting threshold, you can exercise your vested stock options anytime, but you must remain with the company.
  • Some companies may allow early exercise of stock options before vesting, where you can exercise them immediately after receiving the grant, but they will continue to vest based on the original schedule.
  • Understanding your company's exercise period after leaving the organization is important, as you may still have a limited window to exercise your stock options.
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Steps to Carry Out the Stock Option Exercise

To exercise stock options, one should pay heed to certain steps.

  1. Recognize the Terms. Know the specifics of your stock option plan, such as the type of options, the exercise price, the expiration date, and any additional conditions or restrictions.
  2. Check Eligibility. Based on the vesting schedule and any other requirements outlined in your plan or agreement, be sure you are qualified to exercise your stock options.
  3. Determine the Price. Determine how much it will cost to exercise your stock options. To arrive at this figure, the exercise price per share is multiplied by the number of shares you desire to exercise.
  4. Arrange Funds. Ensure you have the necessary funds to cover the cost of exercising the options. This can be done through personal funds, loans, or other financing options.
  5. Notify the Company or Broker. Inform your employer or broker about your decision to exercise the stock options. They will provide the necessary forms and instructions to initiate the exercise process.
  6. Complete Exercise Documentation. Fill out the required forms accurately and provide any additional requested information, such as the number of options exercised, payment method, and desired shares.
  7. Submit Exercise Instructions. Send the completed documentation to the designated party within the specified timeframe. Depending on your company's procedures, this may involve physical paperwork or an online platform.
  8. Pay the Debt. Pay the stock option's exercise price. Depending on your options, you can do this with cash, a cheque, a wire transfer, or by giving up existing shares.
  9. Obtain Stock. You will receive the appropriate shares of stock in your account after your exercise request has been processed and payment has been received. Usually, these shares will be moved to a brokerage or custodial account.
  10. Handle Tax Repercussions. The tax repercussions of exercising your stock options should be considered. Ordinary income tax or other tax requirements may apply to the difference between the exercise price and the stock's fair market value at the time of exercise. Speak with a tax expert to comprehend the tax implications unique to your circumstances.

It's important to note that the exact process and requirements for exercising stock options can vary between companies and plans. It's recommended to refer to your specific stock option plan documentation and consult with your employer, broker, or financial advisor for guidance tailored to your circumstances.

Key Terms for the Stock Option Exercise

  • Stock Option: A financial derivative that allows the holder to buy or sell a certain number of shares of a company's stock at a set price within a given time frame.
  • Strike Price: The predetermined price at which the option holder can buy or sell the underlying stock when exercising the option.
  • Expiration Date: The expiration date of the option contract and the right to execute the option have expired.
  • Vesting: The process by which an employee earns the right to exercise their stock options over time based on predetermined conditions, such as a specific period of employment or the achievement of certain milestones.
  • Vested Stock Options: Stock options that have completed the necessary vesting period and are now eligible for the exercise.

Final Thoughts on the Stock Option Exercise

Stock option exercise can be a valuable opportunity for employees to benefit from the company's success. However, it is cardinal to understand the terms, conditions, and tax implications associated with exercising stock options. By familiarizing yourself with the vesting schedule, exercise price, expiration date, and tax considerations, you can make informed decisions regarding when and how to exercise your options. Speaking with a financial or tax advisor can provide additional advice tailored to your situation. Remember, exercising stock options should be part of a comprehensive financial plan aligned with your goals, risk tolerance, and overall monetary well-being.

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