In addition to a guaranteed salary, some corporations offer stock options to employees as part of an overall compensation package. While extending a stock option does not create a taxable event to the company, the acceptance of that stock does create a tax burden on the employee.
Why Offer Stock?
Companies extend stock options as compensation for a variety of reasons. If the company has cash flow problems, offering stock options in the place of an upfront salary allows them to save money, while still providing an employee with an adequate amount of compensation for his position. Stock options may also be extended to executives or salespeople in a company as an incentive in an effort to encourage higher sales and profits.
When a company extends a stock option to an employee, this offer is considered a call option. The option dictates all parts of the stock offering, including the number of shares the employee may buy, the price per share that the employee must pay, and the date by which the employee must make the purchase. As the name indicates, a stock option provides the employee with a choice. The employee may choose not to buy the stock, as well.
When a stock option is part of a total compensation package, the employee may choose to exercise that option and purchase the stock, but the actual purchase of the stock may be done through direct deductions from the employee’s pay. In this case, the stock does not fully belong to the employee until the stock option has been paid for in its entirety. This procedure is known as vesting. The employee may not sell the stock until it is fully purchased, or vested.
When an employee accepts stock options, the value of those options is considered income for IRS purposes, and the employee must pay taxes on the stock just as he would any other income. Taxes must be paid only on the portion of stock that has vested, however. If the employee has a stock option for $10,000 worth of stock, for instance, but only $1,000 of the stock becomes vested in a year, only the $1,000 of vested stock must be declared as income. If the stock pays dividends, however, the employee must declare these dividends as income as well.