By Steven Zeller

Steven Zeller

Employee stock options have become a popular way to supplement employees’ income, but few employees understand how they can be left holding the bag if they leave their jobs.

A stock option is the right to purchase a company’s stock now or in the future at a currently established price. To tie benefits to stock ownership, the company uses stock options, which gain value as the price of the underlying security appreciates, as a long-term incentive to retain valued employees.

There are two types of options: incentive stock options (ISOs) and nonqualified stock options (NSOs). These option types differ mainly in the tax consequences to both you and the company granting them.

Although the provisions governing a company’s stock options are outlined in plan documents, many employees still don’t understand what will happen to their options if they leave their employers. When you leave your job, your employer - not you - decides what happens to your stock options.

When you leave your job, whether you’re fired or you quit, you generally have only 90 days to exercise your vested stock options. After the 90 days, the options no longer can be exercised. In addition, your options stop vesting on the day you give notice that you are leaving your job, and any unvested stock options are immediately canceled.

If you are laid off, your employer may decide to be more generous with how your stock options are handled. For example, your options could continue to vest for one more year or, in some cases, all of your unvested options may immediately be vested. However, even if your company gives you a year to exercise your options, if those options are ISOs they turn into NSOs in 90 days. The disadvantage of holding NSOs is that the spread between the market price on the day you exercise the option and the price at which the option was granted is taxed at ordinary income tax rates. In comparison, the spread on ISOs is not immediately taxed (but may be subject to the alternative minimum tax).

If you quit your job, some companies can recapture profits from stock options you exercised previously in what is called a “claw back” provision. Paying back the company profits from previous exercises can be a problem, especially if you sold the shares and spent the proceeds.

If you’ve accumulated enough wealth through stock options and other benefits and decide to retire earlier than the company’s stated retirement age, the company may classify your retirement as a termination and possibly cancel all your stock options or require that they be exercised within 90 days or less.

When exercising your stock options, you need to determine whether you are interested in holding the shares of stock that you receive from your exercise or want to sell the shares and invest the sale proceeds in other securities. Unfortunately, some employees choosing to hold the stock mistakenly exercise their options when the market price of the shares is much higher than the exercise price, which increases their tax bill. If you want to hold the stock, you should exercise the options when the market price is as close as possible to the exercise price to minimize taxes.

Another important fact to keep in mind is that most stock options expire within 10 years. Your best defense is to carefully read your stock option documents and understand their provisions.

Steve Zeller is a financial consultant with A.G. Edwards & Sons, Inc., member SIPC, 379 Lytton Ave., Palo Alto 94301. The phone number is 326-5010.