Got your first job at a start up? This workplace perk gives you a shot at a windfall — if you're lucky.
When offered as part of a compensation package, stock options give workers an opportunity to own a slice of the company.
It can be an attractive perk.
Don't declare yourself a millionaire just yet. This employee benefit brings plenty of complexity, as well as a potential tax bite.
"We'll get a phone call from a client, 'Hey! I got options!'" said Dan Herron, CPA and partner at Better Business Financial Services.
"Great, but what did they give you?" he asked. "There's a big disconnect between the information provided to them versus what we actually see."
If you're getting on the ground floor of what could be the next Peloton, your stock options generally will have a pre-set value assigned to them.
You may be granted a certain number of shares based on performance or as part of a compensation package.
Funding rounds from investors drive the value of a private company, but if there hasn't been a funding round, the company will hire a third-party to determine its value, said Eric Bronnenkant, CPA and head of tax at Betterment.
"What's the company worth?" he asked. "It's a tough question. Is their worth based on earnings? On assets? On free cash flow and the types of products they expect to bring to market?"
There are some limited opportunities to trade shares of a pre-IPO company on a private market. However, the board of directors at your firm will need to approve the share sales first, Bronnenkant said.
Publicly traded companies that offer their workers stock options are giving employees a chance to buy a certain amount of stock at a specified price — known as the strike price — following a vesting period at some point in the future.
When you exercise the option, you're buying the stock at the strike price.
Options only have value when they are "in the money."
That is, the market price of the stock at the time you exercise the option is greater than the stated strike price.
The type of option you're offered also matters, as the tax treatment will vary.
Incentive stock options generally aren't subject to taxes when the worker receives or exercises the option. Instead, you pay capital gains taxes when you sell the stock you've purchased.
To qualify for the preferential long-term capital gains treatment — a top rate of 20% — you need to meet three conditions, said Herron.
1. You need to hold the stock for at least two years from the date you received the option.
2. You must hold the stock for more than one year after you've exercised the option.
3. You must have been continuously employed from the grant date up to 3 months prior to the exercise date.
Here's an example of how a transaction might look if it qualifies for preferential tax treatment, per Herron:
John receives some ISO stock options on Oct. 31, 2018. The options allow him to buy 10 shares at an exercise price of $10 per share. John decides to exercise the options on Nov. 15, 2019 when the share price is $20. He then sells the stock on Dec. 31, 2020 when the price is $50, booking a $400 long-term capital gain.
High-income workers should know that the difference between the market price and the strike price could be subject to the alternative minimum tax at exercise, so they should talk to their CPA before they act.
Non-qualified stock options are subject to ordinary income taxes — at a top rate of 37% — upon exercise. That tax is based on the grant price and the fair market value of the stock at the time you exercise the option and applies regardless of whether you decide to keep the shares or sell them.
You're also subject to capital gains tax if your shares appreciate and you sell them.
Since exercising options and selling appreciated stocks can come with a tax bite, you'll need a plan to cover the bill. That might mean you'll have to sell more shares to do so.
You're taking a chance on the success of your potential new employer, so don't get starry eyed at the prospect of ownership.
If you're weighing multiple job offers with stock options attached, do a side-by-side comparison of the other components of the offer.
"I would break the offer package into components: salary, health insurance, dental, student loan assistance and then the stock options," said David Almonte, CPA and member of the American Institute of CPAs financial literacy commission.
That also means assessing your own finances before you settle.
Ask yourself what a comparable offer might look like without the stock options, said Bronnenkant.
"If you're a relatively recent graduate living in New York, you can't pay rent or your student loans in stock options," he said.
"The trade-off on salary and options is easier to make for someone who normally makes $150,000 a year and is willing to take $125,000, plus stock options – they have more financial flexibility," Bronnenkant said.
Ask your company's human resources representative for the stock options plan document, which is also known as a stock option agreement.
This paperwork should have the details on the offering, including the vesting period before you are eligible to exercise your options and what happens if you stop working at that company.
"If you're terminated and not vested, you probably forfeit the options," said Almonte. "But if you are vested, you may be able to exercise within a 60- to-90-day window."
It also helps to understand likely next steps for your company if it's a start-up, as that will have an impact on your stock options.
"Ask about the company's exit strategy and whether they're going public, as well as their time horizon," Almonte said.
Taxes aren't the only reason you should consult your financial advisor or CPA if you have some options in play.
If you decide to exercise and then hold the shares, you may be putting a sizable amount of your nest egg into your employer's basket.
"Any discussion on stock options should also address concentration risk around employer stock," said Bronnenkant of Betterment. "If the company goes bankrupt, they lose the whole investment."
Disclosure: NBCUniversal and Comcast Ventures are investors in Acorns.