Exercising Stock Opions: When Should You Do It?

In the most recent issue of CFO (September 2007), one reader made a very good point about exercising of stock options. Apparently, people often assume that if they hold company's shares for a year after exercising the options, they'll qualify for 15% long-term capital gains rate. Even though a portion of that statement is correct, it is misleading nevertheless. Here is what that CFO reader had to say in the response to magazine's article about stock options:

"When one exercises an non-qualified stock option (NSO), he is taxed on the spread between the option price and the market value of the shares at the date of exercise. He pays income tax at ordinary rates on this spread whether he sells the shares or holds them. This is considered compensation and is also subject to payroll taxes. Future appreciation istaxed at capital gain rates (generally 15%) if the shares are held for more than one year from date of exercise.

"This incorrect tax perspective is frequently offered in conjunction with advice to exercise options at vesting and hold the shares until expiration rather than holding the options until expiration. While this approach will cause a portion of the profits to be taxed as capital gains instead of ordinary income, it requires a cash infusion at the time of exercise. Rather than paying the taxman at vesting, this cash could be invested in shares, which when appreciated, by any amount small or large, will more than cover the difference in taxes."

Now, if you're as "knowledgeable" about stock options as I am, you might wonder what is the difference between the "non-qualified" and "qualified" stock options. Well, as it turns out, there is no such thing as "qualified" stock options, they are called "incentive" stock options (ISOs). So, here are their respective Investopedia definitions to clarify this matter:

Non-Qualified Stock Option (NSO):

• A type of employee stock option where you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.
• NSOs are simpler and more common than incentive stock options (ISOs).
  
• They're called non-qualified stock options because they don't meet all of the requirements of the Internal Revenue Code to be qualified as ISOs.
  

Incentive Stock Option (ISO):

• A type of employee stock option with a tax benefit, when you exercise, of not having to pay ordinary income tax. Instead, the options are taxed at a capital gains rate.
  
• Although ISOs have more favorable tax treatment than non-qualified stock options (NSOs), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.
• Also, numerous requirements must be met in order to qualify as an ISO.

Additional resources:

• Original CFO article ("Lessons in Sitting Pretty") this reader responded to: click here
  
• Full version of the reader's response ("Incorrect Tax Perspective") that I've quoted in this post: click here
  
• IRS explanation of the tax-treatment you can expect when you exercise your stock options: click here
  
• SmartMoney's take on this in "Options: Should I Exercise?": click here
  
• CNNMoney.com - Money101: Employee Stock Options: click here