Not long ago most U.S. employees spent their entire careers working for one company. In exchange for job loyalty, these individuals could count on the financial security of a company-paid pension plan to fund a comfortable retirement.

Today, lifetime employment at one company is no longer the norm. In fact, in many industries it is virtually extinct and a growing number of employees are moving from job to job. In their effort to retain valued employees, many employers are increasingly using stock options.

A stock option is the right to purchase a specified number of shares of stock at a pre-determined price within a specified time period. Many recipients think stock options automatically mean "money in the bank," but that is not always the case. A stock option plan is often a complicated financial agreement accompanied by complex rules.

If you are currently participating in a company stock option plan, or are considering taking advantage of a stock option opportunity, you should know that:

• you can exercise stock options and create taxable income without receiving any money—and still owe various taxes; and
• you could save thousands of dollars in taxes just by knowing the right tax strategy for your situation.

Let’s take a closer look at stock options to understand their value and how they can be used to your advantage.

A stock option agreement describes how and when options can be exercised. Typically the exercise price is set at or near the value of the stock when the options are granted. The options are often exercisable in stages and usually expire after 10 years. Some companies will loan employees the money to exercise options or allow "cashless exercise." With cashless exercise, the employee can borrow the money from a brokerage firm to exercise the options, and then sell the stock immediately, using part of the proceeds to repay the loan.

There are two major types of stock options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NQSOs). The major difference between them pertains to the tax consequences associated with their exercise. Simply put, ISOs may qualify for favorable tax treatment, while NQSOs generally will not.

ISOs typically do not result in ordinary (compensation) income upon grant or exercise. Generally, if you meet the holding period requirements for ISO treatment, you pay no regular federal income tax until you sell the stock acquired by exercising the options. At that time, the gains are treated as capital gains and taxed at the favorable long-term capital gains rate--provided the options are exercised and the acquired shares are sold in a manner that constitutes a qualifying disposition. Note: Even with a qualifying disposition, the exercise of the ISOs may result in some alternative minimum tax (AMT).

In contrast, NQSOs have fewer rules and limitations. However, when you exercise an NQSO, you incur ordinary income equal to the difference between the value of the stock received and the exercise price of the option. If you are an employee, this income is subject to withholding.

An employee receiving NQSOs generally may be taxed at any one of the following times:

• at the time that you exercise the option;
• when you sell or dispose of the option; or
• when the restrictions (if any) lapse on the disposition of the stock acquired by the option. This is the case when the restrictions are such that there remains a substantial risk of forfeiture.

As explained above, employees who receive ISOs are generally not taxed until they sell or dispose of the stock.

Without the expertise to properly manage this investment, the likelihood of paying higher taxes unnecessarily is very high. Given this fact, consider conferring with an expert to develop a strategy for exercising your stock options to help minimize your tax burden and assist you in meeting your financial objectives.

© 2006 Bara Business & Investment Group, Inc.  All rights reserved.