How to Understand Employee Stock Options

Know the advantages of employee stock plans for both employers and employees. Employers use stock option plans as a means of providing a noncash benefit to employees that can help them save for retirement. It also provides them with an in-house market for their stock. Employees get to participate directly in the profits of the company and gain an additional avenue to save for retirement.

Understand the basic components inherent in all types of plans. Virtually all plans have three key dates within them: grant date, exercise date and sale date. The length of time that elapses between these dates often determines the tax treatment accorded to the sale. Most plans allow employees to purchase company stock at a price below its fair market value as an incentive for participation.

Consider participating in a straightforward Employee Stock Purchase Plan (ESPP), where employees purchase shares of their company at a price up to 15 percent below its current market value. This is usually done through payroll deduction, and the length of time between grant, exercise and sale will determine the tax ramifications of the sale. Some plans have taxable consequences when they are granted, others upon exercise.

Participate in a Nonstatutory, or Nonqualified, Stock Option plan to receive straightforward tax treatment of the gain you realize between the stock price at the time of grant and the price upon exercise. If you qualify, you may be eligible instead to participate in a Statutory, or Incentive, Stock Option plan. These plans have tax consequences upon grant, and the discounted portion of the stock price may be a preference item for the alternative minimum tax.

Buy your employer's stock through a qualified plan with an Employee Stock Ownership Plan (ESOP). These plans provide the same benefits as other types of qualified plans and the same tax treatment. They also provide small businesses a liquid vehicle for selling closely-held stock. However, these plans are not very common.