Like many other Internet and tech companies, Stacey's company abandoned its planned IPO due to market conditions. Her remaining options are now underwater. She has also received a significant tax bill and has no money with which to pay the bill.

Unfortunately, Stacey's situation is becoming too common. The change in the stock market has left many employees with worthless options and significant tax bills. This situation could have been avoided if Stacey, and others like her, understood stock options and their practical and tax consequences. The purpose of this article is to provide a basic understanding of the workings of stock options, to highlight the need for careful attention to their management, and to provide some strategies for negotiating stock options with your employer.

The Basics

Once reserved only for executives and senior managers, stock options have become common compensation for all employees, contractors and consultants. Indeed, the National Center for Employee Ownership estimates that between 7 and 10 million employees now receive stock options in the United States. As a result, it is extremely important for an employee to understand stock options more than ever before.

A stock option is a right for a holder to purchase a certain amount of stock within a specified future time period at a predetermined price, referred to as the "strike price." The strike price is fixed at the time the option is granted and usually is based on the stock's then-current market price.

The option holder generally earns the right to purchase, or exercise, his options at the strike price after the options have vested. Vesting usually takes place over a period of time, three to four years in most tech companies. Shares vest at set intervals--yearly, quarterly or even monthly. For example, if the vesting schedule calls for annual vesting spread out evenly over four years, then every 12 months 25% of the stock option grant will vest. Shares can also vest based upon an employee's performance, such as achieving certain milestones or promotions. Once an option vests, the employee generally is free to exercise it at any time by paying the company the strike price. The employee will then receive shares of stock.

The decision to exercise an option depends on whether your options are "in the money" or "underwater." An option is in the money when the strike price is lower than the value of the stock underlying the option. An option is underwater when the strike price is greater than the value of the stock underlying the option. Generally, you should not exercise your options if they are underwater.

The decision of whether to exercise or hold an option can be a complex one. It is not just enough to know whether the options are in the money or underwater. You also need to understand the different types of options and the tax consequences associated with each type of option.

Types of Options

There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). The primary difference between the two is the way that the tax code treats each one.

An ISO is typically designed to grant employees an option that can be exercised with no ordinary income tax liability. The "spread"--the gain between the stock's price and the strike price--can qualify for capital gains tax treatment. To qualify, the stock must be held for two years after the option was granted and one year after the option was exercised. Any sale that does not meet these qualifications will result in the employee reporting the spread as ordinary income that will be taxed at the higher ordinary income tax rate.

An NSO refers to the variety of options that fail to qualify as an ISO. Typically, NSOs are granted to rank-and-file employees, consultants and contractors. Companies generally prefer to give NSOs because the "spread" is deductible as compensation by the company when the holder exercises the NSOs. The holder of an NSO does not receive any preferential tax treatment. When the holder exercises his options, he will be taxed at the ordinary income tax rate on the difference between the stock's price and the strike price. The company is required to collect withholding taxes and any applicable payroll taxes. However, once the stock is held for more than a year, the further appreciation of the stock after the initial spread will be taxed upon a sale at the lower capital gains rate. One advantage of NSOs is that, unlike ISOs, most are transferable to spouses.

Beware of the Tax Man

Stock options come with significant, complicated and costly tax issues. For example, ISO holders are often surprised to learn that they may have to pay the IRS significant alternative minimum tax (AMT) when they exercise their options. Although there is no compensation income to report when you exercise an ISO, the exercise may trigger an alternative minimum tax. You must report the spread at the time of exercise as a positive AMT adjustment, which, if large enough, will create an AMT liability for that year. The tax laws exempt $40,000 for couples filing jointly and $33,750 for single filers. In other words, you will have no tax if the positive AMT adjustment is $40,000 or less for joint filers.

The AMT certainly is an issue. There are, however, some strategies you can employ to minimize or avoid your AMT exposure. First, you can consider exercising your options while the spread is small. Second, you can stage your exercises over several years. There are other, more sophisticated strategies that are beyond the scope of this article; and, these strategies should be discussed with your financial and legal advisors.

Negotiating with Your Employer

Armed with this basic knowledge of the workings of stock options, you should consider some suggestions when negotiating with your new employer or planning for your existing options:

• Always get it in writing. This should go without saying, but you would be surprised by the number of employees at start-ups who sign on without ever having anything about stock in writing.

• Read the stock option plan. Not all plans are the same so you should pay particular attention to vesting, strike prices, expiration date and change-of-control provisions.

• Negotiate an accelerated vesting in the event that there is a "change of control" of the company. A change of control generally occurs when the company is acquired or merged with another. You will want your stock options to vest upon a change of control.

• Negotiate an accelerated vesting schedule. In the high-tech industry, employees typically vest 25% of the grant total each year for four years. Some companies will vest 25% after the first year and the rest in monthly or quarterly installments over the next three years. If you are in demand, you should negotiate a shorter vesting schedule. You can also negotiate accelerated vesting based upon your job performance.

• Negotiate a vesting provision for being terminated without cause. This will protect you against an employer who offers you significant stock options only to fire you for no reason prior to your first vesting.

• A good hedge against future volatility is amassing lots of inexpensive shares, sometimes called "penny shares" because they come with a very low strike price. If possible, you should acquire as many of these options as possible prior to venture-capital funding. As a start-up grows, share prices increase and smaller packages are awarded to employees. Penny-share options are great if the company is acquired or successfully goes public because they can be worth much more than what you paid for them.