Many companies offer shares of their stock as an employee benefit or deferred compensation. Some companies choose to grant employees stock options. Other companies choose to set up a stock ownership or stock purchase plan.
The following summary explains some of the basics of each of these forms of stock-related compensation:
Employee stock options. Employee stock options are often granted to key employees as incentive pay. Employee stock options are call options. A call option gives the employee the right but not the obligation to exercise the option and buy shares of the stock. (A put option is the right but not obligation to sell shares of the stock. Naturally, employee stock options are call options.)
An option is a derivative contract, which means its value is derived from the actual or potential share price of the stock which can be purchased. You exercise options, redeeming them to your employer in exchange for shares of company stock. The price at which you exercise your shares is called the exercise price. (Traders refer to the exercise price as the "strike" price.)
If the shares' market price is higher than the option's exercise price, you can exercise your options and sell them for a profit, less any brokerage fees you pay to sell the shares. A call option with an exercise price below the market share price is in the money. If the shares' market price is below the exercise price of the call option, the option is out of the money. While an out-of-the-money option can't be exercised profitably right away, an employee may decide to exercise the option if they think the market price of company shares is headed higher than the exercise price.
There are two types of employee stock options. For nonqualified stock options, you owe income taxes in the year you exercise the options. The tax is based on the difference in share and exercise prices.
The other type of employee stock options is incentive options. During the Internet heyday of the late 1990s, a few unlucky employees who exercised these options got stuck with huge tax bills under the alternative minimum tax. These options are taxed when the shares of stock are sold. See your tax advisor for the relationship between the alternative minimum tax and capital gains tax as it relates to incentive stock options.
In order to be eligible to receive stock options under most plans, employees are required to vest.
The following table shows an example of exercising stock options. Assume you are granted 10 options that can be exercised for 100 shares each. That gives you the chance to buy 1,000 shares should you exercise all the options. If the market share price of your company's stock is $12 and the exercise price is $20, your options are out of the money: You can buy them cheaper on the open market. They are out-of-the-money $8,000. If the market share price rises to $24, however, your options are now in the money $4,000:
in the money
out of the money
Employee stock ownership plans. Employee stock ownership plans (ESOPs) are a form of deferred compensation. ESOPs contribute company shares to your retirement account. As an employee, you don't incur an out-of-pocket expense for ESOPs. Stock bonus plans are one type of ESOP.
When you leave your employer, you can sell the shares at either the market price (if a publicly traded firm) or fair value (if privately held). The Employee Retirement Income and Security Act (ERISA) ensures that employers comply with regulations to allow employees to diversify their retirement accounts when they reach age 55 and then again at 60.
The National Center for Employee Ownership, a nonprofit organization, estimates that as of May 2007, there are 9,650 companies in the U.S. that provide benefits to about 10.5 million employees use ESOPs as part of their deferred compensation plans.
Employee stock-purchase plans. Employee stock purchase plans (ESPPs) are different from ESOPs. Instead of being considered deferred compensation, employee stock-purchase plans are an employee benefit. These plans let employees buy shares of their employers' stock at a discount to the market price. This discount is often in the vicinity of 15%, which means an employee can buy the shares at 85% of the market price.
An employer holds shares used for its stock-purchase plan in a custodial account. While the hope is that an employee holds on to their shares and works harder to increase the value of their investment, some employees choose to eventually sell their shares on the open market.
The above information should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.