Updated: May 3, 2013 12:14PM
Originally published: August 7, 2001
Do you know your stock options--or at least what they’re worth?
Surprisingly few people do.
Yet more than 12 million Americans--one of every 10 private sector employees--have been awarded company stock options.
And a new Oppenheimer Funds survey shows that 11 percent of survey respondents had actually allowed valuable “in-the-money” options to expire worthless. That’s just throwing money away.
But that’s only one way to lose money on options. Millions of employees have counted their stock options as a significant portion of their wealth. But a decline in stock market fortunes has rendered many of those options currently worthless--underwater in the parlance of the markets.
Surely, if the stock rebounds before the options expire, there could be some future value to the options.
But now’s the time to figure out exactly where you stand--and what you should be doing about your options. Making the right decision can make a substantial difference in your net worth--and in your tax bill. Corporations face some equally touchy problems on the subject of options.
In the past decade, many companies came to rely on stock options as an important part of total compensation. Technology companies made particular use of stock options, not only as a way of attracting and motivating employees, but because granting options saves on cash payouts for wages. It’s not as if options have no cost to a company. Eventually, the company will have to buy in or issue stock when these options mature--if the options have value.
That’s a potentially expensive issue for companies like Microsoft, which have made liberal use of stock options.
In the meantime, as stock prices fall, companies are faced with another dilemma: how to retain and motivate employees whose options have a striking price far above the current stock price.
In short, what can the company do for disappointed employees whose options are underwater? It might seem ideal to simply “reprice” the options at a lower level--but that can cause a big accounting charge against earnings.
And if the company just issues more options, institutional investors will be wary of their stock because of this huge potential liability of outstanding options. So just as individual employees must grapple with the impact of options, companies have option problems, as well. So you have decisions to make along the way.
For example, if an option has a grant price of $25 a share, and the stock is currently trading at $40, your immediate profit, if you exercised the option and sold the stock, would be $15 per share. But if the option has a few years to run, you might wait before exercising it--unless you think the stock is going to drop. Before you do anything with your options, you should understand the tax implications.
That same Oppenheimer Funds survey revealed that 37 percent said they probably know more about Einstein’s Theory of Relativity than about the tax implications of exercising options!
That probably means a visit to your tax adviser as well as the company human resources department to make sure exactly which of the two types of options you have. The two types are:
* Nonqualified Stock Options (NSOs) are the type of option most frequently granted to employees. When you exercise this type of option you will pay ordinary income tax on the difference between the strike price and the stock price. In other words, any gains on the option are treated as ordinary income. So, if you decide to put up cash and actually buy the stock at the grant price, any subsequent gains from the stock price on the day you exercise until the day you sell will be treated as short- or long-term capital gains, depending on how long you hold the stock.
* Incentive Stock Options (ISOs) are the kind that were typically granted to top level management, although many companies now offer them to many levels of employees. There’s a slightly better tax deal for holders of these options. You’re not required to pay any ordinary income taxes when you exercise the options. Instead, you pay capital gains tax on the difference between the original grant or strike price, and the price at which you sell the stock. Yes, you can exercise the stock and sell it immediately.
But you’d pay short-term capital gains taxes, at the same rate as ordinary income. Or if you hold the stock for a longer period (currently one year) you will qualify for the far lower capital gains tax rates. Even if you do exercise your options, hold the stock, and qualify for long-term capital gains rates, you might still be hit with the dreaded Alternative Minimum Tax. See your accountant! Make sure you know what kind of options you have, the tax implications, their current value and the potential impact on your own financial situation. Remember, it’s your option!
And that’s the Savage Truth.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail at savage @suntimes.com. Her third book, The Savage Truth on Money, recently was published by John Wiley & Sons Inc.
*** BUY LOW, SELL HIGH
Each option grants you the right to purchase a share of stock in the future at a price set today--the “strike” or “grant” price. Each option has a fixed length of time before it expires, typically 10 years. And the company may impose other restrictions. It’s important to understand that company stock options cannot be freely purchased and sold, as with options traded on the exchanges.
These are private company options. As an employee, you do have the oppportunity to exercise your option--that is, put up cash to own the actual stock at the grant price of that particular option. When you exercise your option, you can either hold the stock or sell it. In fact, most companies set up programs that allow you to exercise options and immediately sell the stock, without even putting up the purchase price.