Why Your Employees Must Understand Their Company Stock Options

If you’re like many small companies, you’ve granted stock options or restricted stock to reward employees to reward and retain employees.

There are several important things your employees need to know about these equity incentives. Exercising stock options and selling shares in an untimely manner could result in a significant and unexpected tax burden. Holding on to too many restricted shares could increase investment risk in their portfolios.

If you don’t provide guidance on these issues, any mistakes employees make could result in them leaving your company — or possibly take you to court.

That’s why it’s important to help employees avoid taking actions they can’t “undo” later and plan ahead for tax consequences before they have the opportunity to cash in.

What employees need to know about company stock options

Your employees need to know exactly which kinds of restricted stock and stock options they own and the consequences that could result when they exercise or sell them — or if they do nothing at all.

Concentration risk of restricted stocks

If you award employees restricted stocks, they need to be aware that holding large numbers of shares creates “concentration risk” in their investment portfolio because too much of their net worth is tied to the value of your company.

If you go through a rough patch, this could wipe out much of the value of their shares. They need to understand the benefits of liquidating some of their vested shares and using the proceeds to build a more diversified mix of stock, bond, and mutual fund investments.

The tax consequences of exercising stock options

Chances are, most of your employees don’t know how stock options work and what happens when they exercise them. It’s critical for them to understand how they work and how they’re taxed.

For example, if you award Incentive Stock Options (ISOs), they need to know that when they exercise some or all of their options they’ll need to pay for the purchase of these shares either from their own money or by selling a portion of their shares to cover the cost of exercising them.

They also need to understand that if they want to avoid paying ordinary income taxes when they sell their shares they must hold them for at least a year after purchasing them and at least two years from the time they were granted. If they wait, their profits will be taxed at lower capital gains tax rates.

Likewise, if you award non-qualified stock options (NSOs) they must be aware that they’ll take a tax hit right away when they exercise them — there’s no tax benefit to holding exercised shares for an extended period.

The difference between the exercise price and grant price will be taxed at their ordinary income rate and these taxes will be withheld when these shares are exercised.

Helping employees liquidate private shares

Some employees may not want to wait until your company “goes IPO” to  exercise their vested stock options. In these situations, you may want to help them find a growing number of online marketplaces that enable them to sell their options.

Help employees get the professional guidance they need

Your firm is probably not in a position to offer employees personal finance or tax advice on these complicated issues. But you can still point them toward resources that can help.

Ask your company stock administrator to provide links to educational content. You may also want to point them to Mystockoptions.com, which offers a wealth of information on various topics relating to restricted stock and stock options.

If they’re asking you for personalized guidance, consider recommending that they seek assistance from an unbiased fiduciary financial adviser who specializes in tax and stock options planning. There aren’t many advisers who have this level of expertise, and they may be hard for you or them to find on their own. One option you may want to consider is to direct them to Wealthramp.com.

(Disclosure: The author of this article, Pam Krueger, is the founder and CEO of Wealthramp)

There, your employees can be matched with a fully vetted fiduciary financial adviser. The advisor will help them understand their options and also offer financial planning and investment guidance to help them use these potential windfalls to achieve their unique financial goals.