Employee stock options (ESOs) are a form of compensation many companies utilize for various reasons but most often to recruit and/or retain employees. ESOs are also frequently associated with startups—rewarding employees if and when a company goes public—as well as large employers whereby employees are incentivized to help the organization grow and share in its success.

Types of employee stock options

Companies generally offer two types of stock options to their employees: non-qualified stock options (NQSOs) and incentive stock options (ISOs).

From an employer’s perspective, NQSOs are typically preferable as they can be granted to both employees and non-employees—including consultants and board members—whereas ISOs are only offered to employees. The most notable differences between each, however, relate to their tax treatment (more on that later).

How employee stock options work

Employee stock options give employees the right to buy a specific quantity of company stock shares at a precise price (known as the “grant,” “strike,” or “exercise” price) for a specific period of time (the “expiration date”).

To illustrate, let’s say you were issued employee stock options on January 1, 2025 (the “issue date”). Furthermore, your ESO contract stipulates you have the right to buy 10,000 shares at $5 per share and are required to do so by January 1, 2035 (terms are typically 10 years or less from the date of the grant).

Let’s also assume that after two successful years, the company’s stock price increases to $10 per share (the “current market price”) on January 1, 2027. Should you decide to exercise (purchase) your options at this time, you’d make $5 per share or $50,000 in profits (excluding taxes, fees, and commissions).

Your choices when exercising employee stock options

There are several ways in which you can exercise employee stock options. Let’s discuss the most common strategies:

One option is to pay cash for the shares and then hold onto them (also known as an “exercise-and-hold” transaction). In this scenario using our previous example, you’d send the brokerage firm managing the transaction $50,000 and receive 10,000 shares in return ($5 per share). Keep in mind, however, that you’ll likely pay brokerage commissions, fees, and taxes if you decide to go this route.

Another approach is to initiate an exercise-and-sell transaction (also known as a “cashless” transaction). In this scenario, you exercise your option to buy and then sell acquired shares concurrently without using your cash (i.e., the brokerage firm managing the transaction essentially fronts you the money). The proceeds you then receive are equal to the value of the stock (in our example, $100,000 in 2027) minus the grant price ($50,000), required tax withholding, and any brokerage commissions and fees. This choice provides you with cash to use however you’d like.

As a third option, an “exercise-and-sell-to-cover” transaction is similar to an exercise-and-sell transaction; but instead of receiving your proceeds in cash, they remain in the form of stock. Therefore, if the dollar value of what you’re owed is $35,000 and the stock is worth $10 per share, you’d receive 3,500 shares.

Finally, a fourth option materializes as a stock swap—more beneficial for ISOs—whereby you exchange company shares you already own to pay for new shares obtained by exercising your stock options.

For example, let’s assume you already own 1,000 shares of company stock worth $10 per share ($10,000 total). You then decide to exercise 1,000 ESO shares at $5 per share, effectively giving you “control” over 2,000 shares. With a stock swap, you’ll pay the exercise cost of $5,000 with 500 shares of stock you already own.

As for related benefits, this strategy eliminates the need for cash to exercise options and limits your exposure to the company as you’ll ultimately “control” fewer shares (1,500) than you did pre-swap (2,000). You also won’t pay any taxes on share swapping.

Employee stock option tax implications

Unfortunately, tax obligations can be considerable depending on specific stock option types, how much they’re worth, and when exactly you decide to exercise and sell.

Taxation with respect to NQSOs—the most common type of ESO—begins at the time of exercise (the most painful type of exercise!). When you exercise your NQSOs, the federal government taxes this as ordinary income based on your W-2 reported by your employer. The amount of income reported, meanwhile, is the difference between the market price/value of the stock and your exercise price (also known as the “spread”). While it perhaps seems odd to do so, the IRS taxes at the time of exercise because you’re buying shares at a significant discount from the current market price—and the IRS therefore views this as compensation earned.

Selling your NQSO shares triggers a second taxable event whereby you pay taxes based on how long you held them. If you exercise options and sell shares at the same time, you’ll likely pay ordinary income tax on the difference in the spread. If you sell your shares within one year of exercising, meanwhile, you’ll pay a short-term capital gains tax (equal to your federal income tax rate) on the profit you made. Finally, if you sell your shares after holding them for more than one year post-exercise, this is considered a long-term capital gain and thus taxed at a lower rate than a short-term capital gain.

While no taxes are due when you exercise ISOs, this action may trigger an alternative minimum tax (AMT) if your income is over $85,700 (for single filers) or $133,300 (for those married and filing jointly), based on 2024 exemption amounts. The spread between the market value of the stock and the option's strike price is considered income for AMT purposes.

As with NQSOs, selling ISOs will also trigger an additional tax that ultimately depends on whether the sale meets specific criteria for a qualifying disposition or is considered disqualified.

If you dispose of your shares at least one year after you exercised them and at least two years after they were granted, this action summons a qualifying disposition; when triggered, any profits made from selling your stock are taxed as long-term capital gains, which, again, fall below income tax rates.

If you fail to meet qualifying disposition criteria, your stock sale will summon a disqualifying disposition and thus force you to pay more in taxes.

When you should exercise employee stock options

There isn’t a one-size-fits-all approach here, as how and when to exercise your employee stock options ultimately boils down to your own individual circumstances. However, as a rule of thumb, only consider doing so if your stock options have value.

For example, if the market price is higher than your strike price (meaning you’re “in the money”), you can exercise and sell shares and then pocket the difference (the “bargain element”).

Better yet, if you believe the stock price will continue to climb and can afford to hold onto your shares for a year or two longer, you may want to exercise and do this to pay a little less in taxes.

Other employee stock option considerations

Remember that the vesting period is the length of time you’ll need to wait until you can exercise your employee stock options, with ESOs generally vesting in chunks over time at predetermined rates as outlined in your contract.

For example, your company may have a five-year vesting schedule that grants you the right to purchase 20% of your shares following each year of employment with the company. Alternatively, a shorter vesting period (let’s say four years) may have a one-year cliff: meaning that after the first year of employment, 25% of your shares are vested with an additional 1/48th (48 months=4 years) of options vested for each month you’re employed.

Some companies offer ESO plans with reload options, granting you additional ESOs when you exercise currently available ones. These additional stock options have the same expiration date as their predecessors and, generally, a new strike price is set equal to the market value of previously issued exercised stocks.

If you plan on leaving your employer before exercising your vested options, review your ESO contract before making any moves—as you may have a limited amount of time to exercise your options, often up to 90 days from your termination date (although many startups now extend this period to several years).

When you do ultimately exercise your options and then hold onto the shares, remain cognizant of how they impact your overall portfolio as holding too much stock in any one company is sometimes a risky move.

The bottom line on employee stock options (ESOs)

There’s a lot to consider with respect to employee stock options, and, as you can see, related circumstances are sometimes very complicated. Thankfully, a financial advisor can help you develop the best strategy to maximize the value of your own unique options.

Still have questions about what to do with your employee stock options? Schedule a FREE Discovery call with one of our financial advisors.

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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.