Stock options — once considered the icing on the cake, or perhaps the cake itself — of a job offer at a publicly traded company — have lost some of their allure in the now sluggish economy.
“Publicly traded companies — right now, what I’m seeing and hearing is ‘cash is king,’ says Brad Waugh, managing partner of Watch Hill partners, a Providence-based customer relationship management consulting firm.
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In other words, employees may be thinking twice about taking a low salary in exchange for high stock options. And for those with employment packages that include stock options, it’s wise to understand what type of plan they have, and the advantages and disadvantages therein.
Essentially, there are two types of stock options offered by publicly traded companies: non-qualified and qualified.
According to Alan Litwin, of the Providence accounting firm Kahn, Litwin, Renza & Co., Ltd., the difference between a non-qualified and a qualified stock option is primarily one of taxation. With the former, the employee is taxed — based on the difference between what he or she pays and the market value of the stock at the time of the offer — at the time the option is granted.
An employee who participates in a qualified stock option is not taxed until he or she actually exercises the option. At the time of exercise, he or she is taxed on the difference between the employer’s cost and what the market value was at the time of the offer, regardless of the market value at the time of exercise. At the time the option is offered, it must be offered at the stock’s fair market value.
On a non-qualified stock option, an employee is taxed immediately on the gain between what the company offers him or her as the set price and what the stock’s market value is worth. At the time of the offer, the holding period begins.
An employee who purchases stock through a non-qualified option is taxed on what he or she holds as if it were income — depending on the state the person lives in, and his or her tax bracket, the person could be paying taxes on anywhere from 39.6 to upwards of 49 percent of his or her income.
Under both options, an employee has the right to buy stock in his or her company at a set price, or, as it is called the “strike price.” Depending on what kind of package a company offers, an employee may be given the opportunity to take a loan out from the company in order to purchase that stock. The employee typically pays interest on the loan through his or her salary, or in some cases, a lump sum.
If the stock decreases in value, an employee who has borrowed money to purchase stock from his or her company can get doubly hurt, because he or she may own stock that has gone down in value. The employee would still owe income taxes, and he or she would also owe the company whatever amount, plus interest, he or she borrowed to buy the stock.
According to George Warner, senior tax manager and head of the taxation group at the Providence accounting firm Batchelor, Frechette, McCrory, Michael and Co., the most typical scenario he has encountered when individuals lose out on stock options is not when they have borrowed money to buy stock, but when they are hit with what is known as the alternative minimum tax (AMT) on a stock that has fallen in value since the time the option was offered.
AMT, established by Congress to prevent high net worth individuals from avoiding paying any taxes, applies to qualified stock option plans. And it affects more people than Warner believes Congress ever intended.
“It’s gotten uglier and uglier as the years go on,” he said.
For an example of AMT — which currently is between 26 and 28 percent — here is the following (much simplified) scenario:
An employee is offered 1,000 shares of stock options at a strike price of $10 per share. At the time he or she exercises the options, the market value is $50 per share. Thus, the individual has a $40,000 gain (the difference between the strike price and what he or she earned). On an AMT of 26 percent, the person owes $10,400 in alternative minimum taxes.
Though no one enjoys paying taxes, the individual in the example above did pretty well — he or she showed a post-AMT gain of $29,600. But what if the market did not move in his or her favor?
If the same employee saw the worth of his or her options plummet — to a worth of $2 per share on April 15 (which, Warner says, wasn’t all that unusual this past year) — he or she must still pay the alternative minimum tax based on the strike value of the option. Thus, he or she is liable for the $10,400 AMT, although at tax time the total value of the options is a mere $2,000. The individual is running an $8,400 deficit due to the AMT.
