JUNE - JULY 2001  

Stock Options as a Benefit: Are They Worth It?

by Tim Grayson

An increasing number of engineers are being awarded company stock options as a form of employee benefit. In the wild and wooly Internet workplace, these options have been known to make millionaires overnight. Most recipients aren't that fortunate, but options can be a nice added benefit nonetheless. Beware, though; potential pitfalls associated with options can actually cause you to lose money if you are not careful.

What are Options?

Options are just what they sound like: opportunities to buy company stock at a stated price. Suppose a company stock is worth $10 when you receive options as a bonus, for example. A few years later, when you are deciding whether to "exercise" the option, the stock price is up to $30. You can choose to buy a share at $10 (exercise your option) and then sell it back immediately at $30, clearing a $20 profit on each share. Of course, if the stock value went below $10 during that time period, the option would be worthless.

Pros, Cons and Catches

As long as the stock price goes up, options are wonderful. When stock price dip below the original option price, however, the options become worthless. If you were playing options on the stock market, you would just have lost your entire investment, but since your employer gave you the options as a benefit, you haven't made money, but at least you haven't lost any. Or have you?

There's a catch. To the IRS, two types of stock options exist: Incentive Stock Options (ISO) and Nonqualified Stock Options (NSO). If you exercise an ISO, you pay no special taxes. The only tax you pay is the capital gains tax on the gain on the stock. Looking at the example, if you sold at $30, you would be required to pay capital gains on $20. If you hold the stock instead of selling immediately and it then crashes, then you do not make any money — but you also pay no taxes.

If you exercise an NSO, however, you must pay income tax on the paper profit at time of exercise. In this example, you would pay income tax on $20. Not only is income tax typically a higher tax than a capital gains tax, but there is also more bad news. Say you exercised your option and then paid tax immediately on the $20 in paper profit per share. Suppose rather than selling immediately, you held onto the stock and its value dropped to $5 soon thereafter. Now you not only have lost money on your stock purchase, but to add insult to injury, you have already paid income tax on the paper profit — profit you never actually realized.

The bottom line is this: If you have a choice, ask for ISOs instead of NSOs. If you do not have a choice, wait until you are going to sell your stock to exercise your options.

The bottom line is this: if your employer allows you to choose between ISOs and NSOs, choose the ISO stocks. If you cannot choose between the two and are offered NSO options only, you may want to avoid exercising those options until you are going to sell the stock immediately.

Tim Grayson is a program manager at DARPA Tactical Technology Office in Arlington, Va., and chair of the IEEE-USA Engineering Employment Benefits Committee.