Northeastern University’s Online Master of Science in Finance prepares students for a number of im Read More
Any form of compensation for professional work other than cash wages is often called an employee benefit. The standard group of benefits extended to workers is known as the benefits package, and often includes things like health insurance coverage, paid vacation time and enrollment in a retirement plan. Another common component of corporate benefits packages is the employee stock option (ESOs). Managing these financial instruments is a job that can be confusing for anyone without institutional investment experience. A Master of Science in Finance degree from Northeastern University’s D’Amore-McKim School of Business can provide the knowledge required to deal with these arrangements.
First, it’s important to know exactly what ESOs entail. An ESO is not a certificate of ownership of any actual stock in a public or private company. Instead, it is a contract that entitles the employee to purchase a certain amount of the company’s shares at a specific time or after a set amount of time has passed. An ESO is similar to an exchange-traded option or call option, since ESOs cannot be traded on the open market until they are converted to shares.
ESOs are usually limited to the company for which the employee works, and come with rules concerning vesting periods and the price at which shares may be sold. For example, an employee may be granted the option to purchase a total of 1,000 shares of the company’s common stock, with a set “exercise” price of $50 per share. The ESO agreement might also stipulate that only 500 of those shares are vested after two years have passed, with the remaining 500 being vested after three years. When options are vested, the employee may convert the options into shares that may be traded, per the agreement.
ESO is often viewed as a way to reward employees for helping the company to meet the goals of its shareholders. Since vesting is usually predicated on tenure, it may also be a way for companies to retain more workers. In the example above, assume that the hypothetical company’s share price increased to $70 on the open market after two years. The employee could then exercise his or her option to receive those shares and sell them at $70 for a gain of $20 per share, or $10,000 total.
ESO contracts often allow the employer to buy shares at the exercise price ($50 per share in the example), sell at the market price and pay the employee the gains from the sale. If the share price has not increased above the exercise price once the employee has vested options, he or she might instead choose to wait to exercise them, or even leave the company and let them expire. In this scenario, the employer will still reserve the right to sell those shares and profit from the gain, provided all terms of the agreement are met.
According to research from the National Center for Employee Ownership, approximately 15.1 million American workers are participants in an ESO or “ESO-like” plan, which includes profit sharing, stock bonuses or another defined contribution plan in which at least 20 percent is invested in employer stock. Of note is the trend of fewer overall active ESO plans in the last 15 years, but more individual participants. The NCEO attributes this observation to the fact that when a company merges or acquires another, the ESO plans are also often combined into one. Across nearly 10,000 active plans are a total of $1.4 trillion in assets held by either the employer or the employees eligible to participate.
Tax treatment of ESOs
According to the IRS, ESOs may be subject to income tax depending on their classification. The IRS does not levy a tax on ESOs that have been granted but not yet exercised, since there is no potential to earn income from the ESO until they have been exercised.
Once those options have been exercised, employers are required to report the details of the transaction in the employee’s Form W-2, as TurboTax explained. From there, one of four things may happen that will influence the final outcome for the taxpayer:
● The employee buys and holds onto the shares: In this scenario, the difference between the exercise (purchase) price and the market price is considered taxable income.
● The employee buys and sells the shares on the same day: Income is derived from the difference between the value above (market price minus exercise price) and the proceeds gained from the share sale, less any commission fees.
● The employee buys the shares and sells them within a year: Treated the same as above.
● The employee buys the shares and sells them more than a year later: The employee will have income from last year’s share purchase included on the applicable Form W-2, but will need to report capital gains from a sale that occurs more than one year later. This can be done using the tax return Schedule D Part II.
To ensure all tax matters are handled correctly, employees who participate in a stock option plan should make sure to receive a copy of the option agreement and hold onto it. It’s also possible that an employer will make a mistake in reporting stock-based compensation, possibly by leaving it off an employee’s W-2. This could cause the employee to owe more in tax than they expected, but can often be prevented by paying close attention to the option agreement and keeping all necessary records on file for as long as needed.
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