Over 90 percent of the Fortune 1000 use incentive stock options as a way of attracting, compensating and motivating their employees. Not only can options greatly increase an employee's overall compensation, they cost the company relatively little because they transfer the source of the employee's income to the public stock market. Section 422 of Internal Revenue Code gives preferential tax treatment to incentive stock option income. The employee is not considered to receive any taxable income upon the assignment of incentive options, and then can only be taxed on the difference between the price at execution of the options and the final sale price of the shares purchased with the options. If, at the time of sale, more than two years have elapsed since the grant date and one year since the exercise date, then the profit, if any, is taxed as a long-term capital gain.
Understand your options. Options come with an assignment date, a grant price and a date of maturity when they become eligible to be exercised. Know the date at which your options become eligible for exercise. If the company fails before that time, exercising stock options becomes meaningless. Similarly, if the shares are trading below the grant or strike price, the options are essentially worthless.
Arrange a cashless exercise. An option represents the right to buy shares of a stock at a specific price. Even though this price can be significantly lower than the current market rate, purchasing all that stock can still be quite expensive. One solution is to initiate a cashless exercise in which the broker holding your options buys the stock for you on credit and then sells enough of it at the market price to cover the transaction. Whatever shares remain are then credited to your account. This approach, however, can create a small tax liability if the sale price is higher than the exercise price.
Consider a stock swap. Another method of exercising options without a cash outlay is to swap currently owned shares and use the proceeds to finance the exercise of the options. This exchange can often be done directly with the employer company itself, but only if you own adequate amounts of stock independent of your incentive options. Instead of cash being credited to the account, the result will be an increase in the overall number of shares owned, making it a good method for those seeking to hold stock.
Pay cash. Of course, if you have the means, you can always simply lay out the cash yourself to exercise the options. This is only desirable if the strike price is below the current market price, making the stock available to you at a significant discount to the market. In almost all cases, however, one of the two previous strategies is employed to avoid a cash outlay in the exercise of options.
Beware of taxes. If stocks purchased with incentive stock options are sold within two years, they're taxed at the capital gains rate, but only on the difference between the exercise price (not the grant price) and the final sale price. If the stocks are held after the exercise for at least two years, any difference becomes a long-term capital gain, assessed at a lower tax rate. If the final sale price is below the exercise price, even if significantly above the initial grant price, the sale might not be taxable at all.
Exercising options periodically instead of all at once can prevent your entering a higher tax bracket. It's recommended that no more than 10 percent of your total portfolio be held in the stock of your employer. This diversification can preserve your assets if the company's share price should unexpectedly tumble.
Stock prices can be volatile, and a company's value can be affected by factors outside its control. Consult with a tax professional before exercising stock options to find a strategy best suited to your particular needs.