When people say stock options, they could be referring to a bunch of different things.† Letís assume that weíre talking about options you get from your employer.† Letís explain this via the following scenario:
I just got hired for SquishCorps Software and in lieu of a large starting salary, they gave me 4000 non-qualified stock options (NQSO).† I read through my companyís stock option plan and it says that 1/8 of my options vest every 6 months (the first vesting is 1 year after my grant date), and that all options expire 10 years from the date of the grant.† I also got a letter that said my grant price was $10 per share.† What the heck does all this mean?
Letís look at this piece-by-piece.† The basic idea of an option is that at some future date, you have the option of purchasing shares of stock at the grant price.† This means that no matter how much stock has gone up (or down) since you got the stock option, you have the guaranteed right to purchase stock at the grant price.† SquishCorps has further opted to not give you all of the options at once; options will vest over time (that is, they become exercisable over time).† Lastly, the options expire at some point in the future (when an unexercised option expires, itís gone...finito...history...in short, worthless.
What does this mean to you, the option holder?† Well, lets say that 3 years have passed and the current stock price for SquishCorps is now $50 per share (hey, its my example!† I can have unreal stock growth!† Letís just say its SquishCorps ďdot comĒ and they deal primarily in the sale and distribution of internet rumors).† Since 3 years have passed, 4 vestings have occurred (3 years Ė 1 year wait X 2 vestings per year = 4), giving you 2000 available options to exercise.† This means that even though the current fair market value of the stock is $50 per share, you can buy 2000 shares of SquishCorps stock at $10 per share.† This is a steal† (You might be asking ďHey, can I get in on this even if my employer is a stingy cheap-skate?Ē† Well, yes, but thereís more risk.† See my Trading Options page.)
Now, you ask, whatís the downside of all this?† You just bought a $50 stock for $10.† Why isnít this just a big fat win?† Well, while its true you just made $40 per share, remember that nothing in life is free.† This means that this money isnít free either.† Someone, somewhere, wants a cut of this amazing appreciation.† Who could that be?† Oh yeah, our pals at the Internal Revenue Service! The IRS is convinced that that $40 per share didnít just appear from thin air.† More specifically, the IRS wants a piece of the action.† Since they view the $40 per share appreciation as ďordinary income,Ē they will tax it at your prevailing tax rate.† (And believe me, if you have more than a few options, you will very quickly hit that 39% tax rate).
Ok, sure, that sucks.† But hey, its more money than I would have had if I didnít have the options, right?† Iím doing my civic duty and paying my share of the taxes, so hey, whatís the problem, right?† Thatís what I thought for the first few sales, but then I started looking a little more closely at exactly how much I was paying in taxes.† I started looking around for a way to reduce my tax burden.† What I found was the age-old axiom:† you want more money? assume more risk.
Basically, in order to reduce the tax burden, you have to assume more risk.† There is no way to get around paying ordinary income tax rates on the amount that the stock has appreciated.† (Ok, there is no legal wayÖIím sure there are an infinite number of illegal ways, most of them involving a sudden departure from the United States.)† Given this absolute, letís focus on other aspects.