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When Should You Exercise Your Nonqualified Stock Options?

05/26/2016

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by Catrice James and Briana Mullenax

Nonqualified Stock Options (NSOs) are the most commonly used form of stock option. NSOs do not qualify for special tax treatments like incentive stock options, but they also have less restrictive provisions under the tax law. In the year of exercise, you are taxed at ordinary rates on the spread. The spread is the difference between the current value of the stock and your option price (also called strike/grant price). Federal income and employment taxes will be withheld by your employer at the exercise date. In the year of sale, you will be taxed at the capital gains tax rate on the growth of your stock after you exercise.

The decision of when to exercise your employee stock options can be challenging. There are important factors you should consider in order to make a wise decision.

When Should You Exercise and/or Sell?

The first step in deciding when to exercise is to look at which NSOs are vested and eligible to exercise. Also, you should not exercise if the current stock price is lower than your option price, (“under water”). Some other factors to consider:

  • Advantages and disadvantages of waiting:
    • What are your expectations of your company’s growth and stock appreciation?
    • Do you believe it has reached its peak?
  • Stock option expiration date:
    • Do you have time to wait or is the expiration date looming?
  • Current and future financial needs:
    • Are you considering selling early because you need to raise cash now for events such as buying a new home or paying for your child’s college tuition?
  • Current and potential future tax situation:
    • Do you anticipate being in the same, lower, or higher income bracket when you exercise?
  • Risk tolerance:
    • Are you willing to tolerate the potential ups and downs of the stock market?
    • Would you prefer a more conservative investment or do you believe an alternative investment will appreciate at a higher rate?
    • Does your portfolio need risk diversification (if the majority of your investments are in your company’s stock)?

What Are Your Choices For Exercising?

There are three basic ways to exercise stock options. You can pay cash, use company stock you already own, or execute a “cashless exercise”. We will describe and illustrate two of those choices – cash and “cashless exercise”.

Paying cash to exercise your options is the least complicated method. You give your employer the cash required to purchase the options (number of options multiplied by the option price). Federal taxes will also be required to be paid.

A stock option plan may also allow option holders to exercise their options using the "cashless exercise" method. Your employer will make arrangements with a brokerage firm, which advances the money needed to buy the stock. The brokerage firm sells the required amount of stock to cover the option cost and taxes owed immediately. There is no cash outflow when this method is used.

Examples – Cash Payment and Stock Tender

You have 10,000 NSOs available at $10, which are vested once received and expire in 10 years. Under each assumption, the option cost is $100,000 and the fair market value (FMV) is in the money. You are being taxed at the highest ordinary income rate (39.6%) plus Medicare tax (1.45%) and Net Investment Income tax (3.8%). Your capital gain rate is 23.8%. Since there is a significant difference between the ordinary income tax rate and the capital gain rate, let’s explore whether to exercise your options early or to exercise them closer to the expiration date. Any fees associated with selling have been ignored on the example.

Cash Payment Assumptions:

  1. Exercise Year 1 and Sell in Year 10 – Current stock price is $10.60, resulting in ordinary income of $6,000, which is subject to $2,691 income tax. Your capital gain is the difference between the Year 10 proceeds $189,830 ($18.98 * 10,000) and stock stepped-up basis of $106,000 ($10.60 * 10,000). The cost to borrow is calculated by compounding 3% annually for 9 years on $102,691 (option cost plus income taxes in Year 1).
  2. Exercise Year 5 and Sell in Year 10 – Current stock price is $14.19, resulting in ordinary income of $41,852, which is subject to $18,771 income tax. Your capital gain is the difference between the Year 10 proceeds $189,830 ($18.98 * 10,000) and stock stepped-up basis of $141,852 ($14.19 * 10,000). The cost to borrow is calculated by compounding 3% annually for 5 years on $118,771 (option cost plus income taxes in Year 5).
  3. Exercise and Sell Year 10 – Current stock price is $18.98, resulting in ordinary income of $89,830, which is subject to $40,289 income tax. There is no capital gain in Year 10 because proceeds equal stock basis. There is also no cost to borrow.

The best outcome illustrated above is to exercise in the year of sale (near the expiration date). In Year 10, you will have the highest net proceeds after tax and the maximum leverage of your money. You will pay more ordinary income tax in Year 10; however, you will avoid paying capital gains tax and the costs associated with borrowing money.

Cashless Exercise Assumptions:

The conclusion that can be drawn from the above examples is this: assuming that the price of the stock can be expected to appreciate over the option term, the benefit of inherent leverage of wealth imbedded in stock options offsets the difference in the ordinary versus capital gain rates. Therefore, the best result is likely to be to exercise and sell at the same time rather than exercising and holding until some later date in the option term. Since every situation is unique, please give us a call to discuss how we can help you determine what the best result is for you.

  1. Exercise Year 1 and Sell in Year 10 – Same ordinary income, income tax, and option cost of $102,691. If you take $102,961 and divide it by $10.60 (current FMV), you get 9,687.83 shares that you must tender to cover costs. You are left with 312.17 shares to sell at your discretion. When calculating your capital gain, the cost basis of your remaining shares will be step-up to the value your stock was at date of exercise.
  2. Exercise Year 5 and Sell in Year 10 – Same ordinary income, income tax, and option cost of $118,771. If you take $118,771 and divide it by $14.19 (current FMV), you get 8,372.86 shares that you must tender to cover costs. You are left with 1,627.14 shares to sell at your discretion. When calculating your capital gain, the cost basis of your remaining shares will be step-up to the value your stock was at date of exercise.
  3. Exercise and Sell Year 10 – Same ordinary income, income tax, and option cost of $140,289. If you take $140,289 and divide it by $18.98 (current FMV), you get 7,390.23 shares that you must tender to cover costs. You are left with 2,609.77 shares to sell at your discretion. When calculating your capital gain, the cost basis of your remaining shares will be step-up to the value your stock was at date of exercise.

The conclusion that can be drawn from the above examples is this: assuming that the price of the stock can be expected to appreciate over the option term, the benefit of inherent leverage of wealth imbedded in stock options offsets the difference in the ordinary versus capital gain rates. Therefore, the best result is likely to be to exercise and sell at the same time rather than exercising and holding until some later date in the option term. Since every situation is unique, please give us a call to discuss how we can help you determine what the best result is for you.

When Should You Exercise Your Nonqualified Stock Options?

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