Employee Stock Options Make Work More Than Just a Job

Once a perk reserved for executives, many publicly held companies now offer stock options to rank-and-file employees. Small businesses do so to give their workers a sense of ownership, providing them with financial incentives to make their companies succeed.

According to the Employee Ownership Foundation about 9 percent of the 114 million private-sector employees in the United States hold stock options, and approximately 18 percent own company stock.

Offering employee stock options gives workers the chance to buy shares in their company at a specified price. The price, called the grant or strike price, should be pegged to the value of the stock when it is offered to employees. Employees have the option of buying the stock at a set price, also called exercising the option, after a period of time and then selling it when they choose.

A simple example: You offer an employee 10 shares in your company at $1 a share, for a total value of $10. Your employee buys the options when the stock reaches $3 a share, and immediately sells his or her shares on the market. The employee has made a profit of $20 before taxes.

Employees are not required to purchase their options, so if the stock price falls below the option price, they won't lose money. However, declining share prices often hurt employee morale. Although many dot-com companies in the 1990s offered stock options to compensate for lower salaries, options should only be given as investment perks because their worth will fluctuate.

Companies must list the options as expenses in financial statements when they are issued, which will probably hurt a company's earnings. Be careful to monitor when options are granted, vested and purchased by your employees. The SEC has investigated companies for improper stock granting practices.

A small business can offer different types of employee stock options:

Incentive stock options. Employees only pay taxes on such options when they sell them. Workers also qualify for the 20 percent long-term capital gains tax if they sell the stock more than two years after they received options and one year after exercising the options.

Non-qualified stock options. Employees generally pay higher taxes with these options. When employees exercise these options, they must pay income tax on the price difference between the market value of the stock and the grant price. Employers get a tax deduction on the difference.

Restricted stock. Companies give employees a certain number of shares that they can sell after the company meets certain goals or after a period of time passes. Employees pay income tax on the earnings when the stock vests or they can pay tax when the options are issued.

Tiare Rath is a freelance journalist and a former personal finance columnist for MarketWatch.com.