Executive Financial Planning

Part 1: The Secrets of Stock Options

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Entrepreneur, Executive Financial Plan, Stock Options, Restricted Stock, Incentive Stock Options, Non-Qualified Stock Options

Climbing the corporate ladder can be a rewarding, challenging, and amazing feeling. While there will certainly be a few extra headaches from the additional responsibilities, there are also a few extra compensation benefits. Whether you are a part of a small or large company, you may find yourself faced with the questions of “What do I do with _____?” or “What is the tax implication when I sell _____?” or “How do I execute_____?”. Each of these questions, when applied to Stock Options and/or Restricted Stock, can be difficult to interpret. In this two part series it is our intention to demystify the nuances of stock options and restricted stock in order to give you a clearer understanding of how best to benefit from your new found wealth.


Stock Options

In the world of stock options there are three types of option ownership you should be aware of. Each are unique in the own way and come with a different set of tax implications. Let’s break them down:
Employee Stock Option Plan (ESOP).

According to IRS code 4975(e)(7), an employee stock option plan is a qualified defined contribution plan used by a company to grant equity ownership to an employee over their tenure with a company. Traditionally -as deemed appropriate by the company- the company grants stock options to its employees equitably. The company then holds those options in a separate trust where they remain until the employee leaves the company, retires, or a liquidation event happens resulting in the employee’s options being cashed out.

Since an employee stock option plan is considered a defined contribution plan it is regulated by ERISA. This means there are certain contribution restrictions employers have to follow, and taxation of these options can be deferred. In other words, employers cannot grant an unlimited number of options to one person, and the options that are granted can be held in a qualified taxed deferred account. Recognition of these options as income is not realized until the funds are withdrawn. To that end, since an ESOP is a qualified plan it is eligible for rollover treatment to an IRA account, thus further delaying the recognition of income taxes until funds are later withdrawn from the IRA account.

Incentive Stock Options (ISO)

Another alternative way to grant employees equity in a company would be to give them Incentive Stock Options (ISO). This differs from an ESOP in how they are granted and vested. It is similar in that an ISO offers a tax preferential benefit. These options are used to grant equity ownership to specific employees instead of requiring an equitable distribution across all employees. Unlike an ESOP, ISOs can be granted in any quantity to anyone allowing the company to use this tool as an “incentive” to hire, retain, or entice an individual.

However, the rules around ISOs are a little more complex. For starters, you need to understand three distinct dates and their correlating price: the grant, the vesting, and the exercise. Let’s peel back the layers of each of these:

The Grant – This is the date and price when the company actually gives you the stock options. While you cannot do anything with them at this moment, this date “starts the clock” on the next two milestones.

The Vesting – Every grant is given a vesting period, or a period of time when the shares are able to be sold. Each vesting period is set by the company, and every company can establish a slightly different vesting schedule. For example, you could be given 3000 shares of option to be vested over three years. This would mean that on each anniversary of the grant date you are able to access, by holding or through liquidation, those 1000 shares. At the end of the three year period all of your options have fully vested and you can do whatever you want with all 3000 shares. It is important to note, some companies put a clause in the options agreement that requires the employee to remain with the company to receive all vested shares, otherwise any unvested shares are forfeited. Check with your company before deciding to make the leap to another company. Also, if you are going to lose valuable equity make sure you factor that into the evaluation of your new employment offer.

The Exercise – This is the moment you decide to do something with the vested options. Since options are a “right to buy” stock at a specific price you essentially need to “buy the stock”. In other words, you need to “exercise the right” to purchase the stock. However, in some cases the stock you are trying to purchase could be worth a lot of money and you might not have the funds to acquire the stock. That is usually fine as many companies work with the clearing firm who holds the shares to perform a “cashless exercise”. This action allows the clearing firm to essentially purchase the stock on your behalf, and then immediately liquidate the equity at the same price, thus transferring the proceeds to you. I have worked with many individuals who have used this strategy when exercising their options.

For tax considerations, it is important to know how these three dates and prices interact together. ISOs can be subject to ordinary income tax, since they were given as a part of compensation. However since their value was not realized at the grant they are not taxable until sold. There is one distinct advantage ISOs offer that should strongly be considered. If an ISO is held for two years from the date of grant, or one year from the date of exercise, then the taxable liability shifts from being ordinary income to that of being a long term capital gain. This then requires the holder to actually purchase the stock at exercise and hold it for at least one year before being able to take advantage of the long term capital gains treatment. If done correctly, and if the funds to purchase are available, then this preferential tax treatment could offer significant long term financial planning benefits.

Lastly, ISOs are subject to Alternative Minimum Tax treatment. Without getting too specific regarding what to add back, when to add it back, and how to potentially take adjustments in the future, it is probably best to work with a qualified tax advisor such as an Enrolled Agent, or Certified Public Accountant.

Non-Qualified Stock Options (NQSO)

The last form of stock option granted by a company to its employees is the Non-Qualified Stock Option. This is much more basic and simple to understand. It operates very similarly to the ISO, but it does not offer the same tax benefits. At the grant, an employee is given a number of shares which are not required to be equitable across the rank and file. These shares are then held through the vesting schedule. Upon being vested they become eligible for exercise and it is at this time, once exercised, that they are treated as ordinary income to the employee. Now if the exercise was done as a “cashless exercise” then the proceeds are given to the employee to pay the taxes and use the remaining as deemed fit. However, if the options are exercised and the corresponding stock is held for a minimum of 12 months then any appreciation, or loss, could be subject to long term capital gain/loss treatment. The distinction of note between the ISO and NQSO, is what happens at the exercise date. If the ISO is exercised and the stock is held for 12 months then ALL gains from the grant are treated as capital gains. Whereas the NQSO will always be subject to ordinary income tax at the exercise and if held beyond exercise then any appreciation or loss beyond 12 months is subject to long term capital treatment.



Stock options can be used as great way to participate in the equity growth within your firm, and if used correctly, can be a significant asset within your investment portfolio. It is important to note, since stock options can be illiquid for a period of time AND can cause large tax liabilities we strongly encourage you to work with a tax advisor and a CERTIFIED FINANCIAL PLANNERTM to build an exit strategy for the proceeds. This will allow you to assess, address, and decide how, or when, to liquidate your positions AND where to re-position those funds for future growth opportunities.

In our next article we will discuss another form of executive compensation, Restricted Stock Units. Similar to stock options, Restricted Stock Units, can be given to the employee as a portion of their compensation. However, in some instances investors can also purchase Restricted Stock from a company. For those who own, or will own, Restricted Stock there are two tax strategies you should be aware of. Helping us understand these strategies we will be interviewing Julie Piché, an Enrolled Agent and the Principal of Foster Financial Group, LLC, for her insights into how investors can apply Sections 83(b) and 1244 of the Internal Revenue Code to their Restricted Stock.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

C-Suite Planning™ (trade name for Horizon Ridge Wealth Management, LLC) along with their advisors, do not provide tax advice. Clients should consult with their personal tax advisors regarding the tax consequences of investing.

Julie Piché with Foster Financial Group, LLC and Horizon Ridge Wealth Management, LLC are separate entities.


About Jon Peyton

Jon is an accomplished Senior Executive, Entrepreneur, and thought-leader with demonstrated success across the financial services, publishing, and exit planning industries. He has worked with thousands of clients and managed hundreds of millions of dollars spanning 20 years for multiple firms.

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