Tax Pitfalls for Employee Stock Options

The growth of employer-sponsored stock options programs has increased the need for employees to understand their stock options and the associated investment, tax and portfolio diversification issues.

So, what is a stock option? It is the right to buy a fixed number of shares of your employer’s stock at a set price. If your option strike price is actually below your company’s present share price on their stock, your options are said to be “in the money.” By example, you might be able to buy the stock at $20 per share and turn around and sell it for $80. Multiply that by hundreds or thousands of options and you are sitting pretty. You have no worries, or do you? Stock options are tricky and small mistakes can cost you big dollars.

We have identified the top ten mistakes people tend to make with their stock options:

  1. They neglect to get professional help. Even when there is a lot of money at stake, some people will try to avoid paying a professional for help and thus they can end up making costly mistakes.
  2. They procrastinate. Many employees severely restrict their choices or miss valuable opportunities because they wait too long to develop a plan or strategy.
  3. They don’t understand the tax law and therefore pay a large “ignorance tax”. That’s what we call the cost of not pursuing an optimal strategy simply because you lack the tools or knowledge to analyze and choose the best alternatives.
  4. They plan for only a year at a time. The strategy one follows this year will have tax consequences in subsequent years. Therefore, it is important to do multiple year tax planning.
  5. They take on too much risk. Many people become emotionally attached to their company’s stock and either neglect to diversify their investment portfolio or do so too slowly.
  6. They guess at the tax consequences¬†of exercising their stock options or follow their friend’s advice, which may be wrong or inappropriate for their particular situation.
  7. They attempt to avoid taxes rather than make money. Employees must look at the overall consequences of their strategy, not just the tax consequences.
  8. They don’t understand the rules for paying estimated taxes. This is one area where an individual can really get hurt: If you estimate incorrectly, you could invoke underpayment penalties or pay too much tax too soon.
  9. They allow options to expire without exercising them. A recent survey reported that 11% of employees allowed their stock options to expire even though they had value. That means that they simply left money on the table.
  10. They do not fully understand the choices and opportunities posed by their options. The provisions of each employer’s stock option grant can vary. So even someone who possesses a general understanding of options may still not know enough to get the most value from them.

 

Here are some examples of how costly these mistakes can be:

      One employee made the mistake of “falling in love” with his employer’s stock and neglected to diversify his position. It looked like a wise decision — until the stock price plummeted. In a matter of days half of his total net worth was wiped out. The remedy for this mistake is to diversify enough to at least protect your basic financial goals.
      One unfortunate professional did not realize that there would be a tax consequence of exercising her stock options. She had held her stock, hoping to take advantage of capital gains tax rates. By the time the tax came due, the stock had dropped in value and wiped out much of her profit. She ended up having to pay taxes on profit she never saw.
    An executive of a rapidly growing company did not understand the interplay of investment issues, tax consequences, and portfolio diversification. Because of this he let the tax consequences dictate his stock option strategy. He held his stock hoping for capital gains tax treatment only to watch the total value of his portfolio drop by 50%.

 

If any of these stories cause you to squirm in your chair, then pick up the telephone and call us for help! Employee stock options are one of the most complicated tax issues around. The stakes are usually high and the punishment for not getting it right stiff. Don’t get caught by one of these costly mistakes, learn from and take advantage of our experience.