I've been blogging about personal finance and investing for more than 15 years, but in all that time, I have never written a post about employee equity incentive plans. The reason is because they're very rare for doctors, who make up a majority of our target audience. I've never been offered any sort of stock option as part of my compensation as a doc, and so I have zero personal experience to write about. However, a fair amount of our audience is composed of tech workers, executives, and other highly compensated employees where stock options are very common, so let's talk about them today.

What Is an Option?

An option is the right but not the obligation to buy (or sell) some sort of asset at a certain price. The option itself has a certain value depending on the price and the value of the asset.

What Is a Stock Option?

A stock option is the right but not the obligation to buy (or sell) a certain number of shares of stock at a certain price. Typically, the right to buy is referred to as a “call,” and the right to sell is referred to as a “put.” You “call in” the stock, or you “put” the stock to someone else. There are entire “secondary” or “derivative” markets where traders swap these options rather than the underlying investments themselves. These are not the options we're talking about right now. In today's post, we're talking about employee stock options.

What Are Employee Stock Options?

Employee stock options are a form of compensation offered to certain employees by their employer, typically a publicly traded company whose stock trades on the market. For the option to have value, the price at which the employee has the option to buy the shares (strike price) has to be below the price at which the stock is currently trading (exercise price or fair market value price). For example, if one has the option to buy 100 shares of a stock at $100 per share and the stock is currently trading at $120 per share, that option is worth $100 * ($120-$100) = $2,000 because you could exercise the option, buy the shares at a discount, and then immediately sell the shares for a $2,000 profit.

Employee stock options are often used as “golden handcuffs.” They can incentivize an employee to work hard to increase the value of the company (so the stock and thus the options are worth more) and to stay with the company for the long term. This is typically done by requiring the options to “vest.” You cannot actually exercise the option until it is vested, and that vesting period usually lasts for years. If the vesting period is five years, that employee is less likely to leave the company after just three or four years because they want to receive that additional compensation for their work that was offered in the form of the stock options.

More information here:

How Are Employee Stock Options Taxed?

Employee stock options are taxed in two different ways, depending on the type of option they are: Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NQSOs).

Incentive Stock Options

ISOs receive better tax treatment than NQSOs because they are not taxed when the option is exercised; they are taxed when the purchased shares are actually sold. For options to qualify as ISOs, however, several rules must be followed.

2-Year Rule

You must wait two years from the time of the grant of the option until the shares are sold or the option becomes non-qualified.

1-Year Rule

You must wait one year from the time of the exercise of the option until the shares are sold or the option becomes non-qualified.

$100,000 Rule

Your company can only vest up to a value of $100,000 per year per employee in option value (as of the grant date, not the exercise date). Any amount above that becomes non-qualified.

Assuming the rules are followed, the taxation of ISOs is delayed until the shares are sold AND the taxation is done at the lower long-term capital gains (LTCG) tax rates rather than ordinary tax rates.

Non-Qualified Stock Options

NQSOs are any stock option where the above three rules are not followed. If you exercise an option after six months, the difference between the strike price and the fair market value at the time of exercise will be fully taxable in the year of exercise at ordinary income tax rates. If you then sell the shares six months later, that sale will not qualify for LTCGs rates either. It will be taxed at short-term capital gains rates, which are exactly the same as ordinary income tax rates.

Employees are sometimes surprised to get NQSO tax treatment simply because the company offered the ability to exercise the options early (even though the employee didn't take advantage of that) or because vesting was accelerated due to company acquisition or termination.

How Does the AMT Apply?

The Alternative Minimum Tax (AMT) is not an additional tax; it is an entirely different system under which taxes are calculated. Technically, everyone must calculate their taxes every year under two systems—the regular income tax system and the AMT system—and pay whichever tax bill is higher. Tax software does this automatically behind the scenes. For most people, their bill is higher under the regular system; the tax software never says anything, and they are probably not even aware of the existence of the AMT system. For a few people (much fewer since 2018 due to the Tax Cuts and Jobs Act), the bill is higher under the AMT system, and the difference is often referred to as “AMT tax.”

The two systems have plenty of differences, but the most important one for our discussion today is that ISOs are not taxable at the time of exercise under the regular system but they are under the AMT system. This “AMT Trap” can catch some unwary employees. The good news is that you get a credit for that AMT tax paid, which is applicable the next time you file taxes under the regular system. This credit is carried forward indefinitely on IRS Form 8881.

What Are Restricted Stock Units?

Restricted Stock Units (RSUs) are not a stock option. They are a promise to give you a certain number of shares at some future date.  The period of time between the grant of the RSUs and when the shares are delivered into your brokerage account is referred to as the waiting, performance, or vesting period. Sometimes the delivery of those units is performance-based or performance- and time-based, but most commonly, it is just based on time.

As soon as the shares vest and show up in your account, the value of those shares on the date of delivery is taxable to you at ordinary income tax rates. Just like with your salary, your employer is required to withhold a portion of the shares (typically 22%-25%) to cover those taxes. When you later sell those shares, the sale will be taxable at capital gains rates just as though you had bought those shares yourself on the day of vesting. If you sell them for a loss, you will get a capital loss on your taxes. If you sell them for a short-term gain after owning them for a year or less, you will pay ordinary income tax rates on the difference in value between the date the shares were paid to you and the date on which you sold them. If you hold the shares for longer than a year, you can benefit from the lower LTCG rates.

Just like employee stock options, RSUs are golden handcuffs that incentivize the employee to work hard to increase the value of the company and to stay with the company long enough to receive the actual shares. The value of a stock option and an RSU both vary with changes in the value of the company. The value of an option is more volatile, and it can actually go to zero if the share price drops below the strike price. But the only way the value of an RSU goes to zero is if the company becomes worthless. If the company is the next Google or Nvidia, you're probably better off with options than RSUs.

What Are Stock Appreciation Rights?

Stock Appreciation Rights (SAR) are the ability to benefit from the appreciation of a stock without ever actually purchasing or receiving shares. They function similarly to stock options. Typically, the company pays out the difference between a strike price and an exercise price as cash, but the company can also pay out with shares of the company. There is no tax due at the time the SAR is granted, but ordinary income tax is due on the value at the time the SAR is exercised. If it is paid out in shares instead of cash, the later sale of those shares is treated as a capital gain (or loss).

What Are Employee Stock Purchase Plans?

Employee Stock Purchase Plans (ESPPs) are simply the opportunity to buy shares of the company at a certain price, typically a price significantly less than the current value. You usually have to be employed at or associated with the company for a certain length of time to qualify, and sometimes the subsequent sale of these shares is restricted for a certain period of time. If the company is not publicly traded, those shares might also be very illiquid.

Decades ago, employees were permitted to invest in company stock inside the company 401(k). Sometimes, the company stock was the only investment in the 401(k), or the employer match consisted of company stock. Aside from golden handcuffs for the employees, a tax break also incentivizes employers to offer their own stock instead of cash.

This situation obviously creates a serious lack of diversification, when your income AND your wealth is all tied up with a single company. That risk showed up most famously with Enron, when 62% of the 401(k) money was invested in the company itself. The employees lost not only their jobs but also a huge chunk of their retirement dollars. Regulatory changes make this sort of thing very rare now. Mostly, you should just recognize what a bad idea it is to have a huge chunk of your financial life tied up with the future of a single company and guard against that risk as best you can, no matter how much you love the company for which you work. Some employees go so far as to short their company stock or buy puts against it to hedge against the loss of value in their employee stock options, RSUs, SARs, or ESPPs.

More information here:

How Should You Take Your Compensation?

The most frequent questions I get about these sorts of compensation plans are from doctors who are being offered some of these in exchange for contributing in some way to a startup. They want to know how much of their compensation they should take in incentive pay vs. a salary of some kind. The answer, of course, depends on the future of that startup company. The better it does, the better off you will be if you take your pay in the form of risky stock options, RSUs, SARs, or ESPPs. The worse it does, the better off you will be if your compensation consists of cash on the barrelhead.

Startup founders face the opposite incentive structure. It's free to them to offer you these sorts of incentive pay structures (or even equity) in exchange for your services (or money), but in the long run, your assistance could end up being very expensive if the company does well. Founders also need to be careful not to give up so much equity that they could lose control of the company to someone else.

What do you think? Which of these have you been offered, and how did it work out? What tips do you have for someone being offered options or RSUs?