You have just been granted a block of company stock options as part of a new stock options program. Thoughts drift wistfully to the fortunes of Microsoft millionaires and Home Depot workers who have cashed in huge options windfalls. Could your company options be worth millions? Brace yourself for the answer: maybe not.

Though the lure of unrealized riches in stock options has been much ballyhooed, the wealth effect has been overstated for the vast majority of American workers.

In fact, unlocking the value of your stock options is tied to understanding fully your alternatives for funding the exercise, your tax implications (including the Alternative Minimum Tax Trap for Incentive Stock Options), and the pros and cons of selling versus holding the stock.

That sounds easy enough, but plan administrators report that many employees lack an understanding of stock options fundamentals, according to Sandra Sussman, executive director of the Concord, California-based National Association of Stock Plan Professionals.

"The need for improved communications stems in part from a sea change affecting the number and levels of employees who are granted stock options these days," Sussman noted.

How They Work

A stock option is an agreement by the company affording you the right to purchase its stock at a particular price during a particular period under the terms set forth in the company’s plan agreement.

The options granted to the rank and file are usually offered at market price on the grant date and they vest, or become eligible to exercise, over a three to five year period.

There are two types of stock options: Incentive Stock Options (ISOs) or Nonqualified Stock Options (NSOs). Differing corporate accounting and personal income tax implications drive companies to issue one or the other.

When you exercise an ISO, the entire gain is generally taxed only when you sell the stock and, if you meet the required holding period, the gain may qualify for favorable long-term capital gains treatment.

Not so with an NSO, whose gain is taxed on the date of exercise. The gain upon exercising an NSO is taxable at an ordinary income rate, even if you plan to hold the shares.

Now that there is a lower capital gains rate, ISOs are back in favor. Many companies are revising their plan documents to load up on ISOs to the extent of the IRS limit, says Art Yonowitz, a senior tax manager with Arthur Andersen LLP. An individual can only vest $100,000 per year in ISOs up to a $1 million limit over 10 years, says Yonowitz.

Picking a strategy

Before you determine which exercise strategy is right for you, consider talking about it with your accountant or financial advisor. "Employees often fail to make the connection between their options and other financial decisions, such as tax and retirement," says Liane Jones, vice president, Employee Investment Services of BT Alex. Brown. "Your options should be viewed within the context of a long term investment strategy, not as a source of cash, as so many view them."

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Your strategy should first take into account certain distinctions between ISOs and NSOs.

ISO must be granted at fair market value, not in-the-money and, when you exercise, the spread is treated as an AMT preference that factors into your tax calculation, Yonowitz explains, referring to an additional tax paid by certain high income taxpayers.

While maximizing the long-term gains from your ISO is the objective, be careful. Your exercise will trigger the Alternative Minimum Tax Adjustment that may put you in AMT in the year in which you exercise -- even if you are not ordinarily subject to AMT.

When you exercise NSOs, you establish a new cost basis -- the fair market value on exercise date. If your goal is to capture much of the appreciation in long term capital gains and you believe in the stock, you should continue to hold it for at least 12 months

This strategy of exercising NSOs to start the capital gains period running should only be employed if you are pretty comfortable that the stock is going to appreciate and you can afford the carrying cost including the tax payment, advisors say.

When you exercise, you are taking the company up on its agreement to sell you the stock at the grant or strike price.

You are "buying" the stock from the company and you will owe the company at that time a sum equal to the grant price times the number of shares and any applicable taxes on NSOs. (Figure your taxes will include 28% federal plus state and local rates that apply). You can finance the exercise any one of several ways:

Pay cash to exercise the options and hold the shares. If you’d rather hold than sell the stock, use cash to pay the option strike price and any taxes that are due at this time on nonqualified options.

Borrow against the value of the stock to finance the strike price and taxes. Brokers may let you borrow against the value of the stock up to the Regulation T maximum of 50% of its value subject to their internal policy limits.

Do a "cashless transaction", that is, a simultaneous exercise of your options and sale of the underlying shares. Your broker will advance you the funds until settlement to pay the company the strike price, transaction cost and applicable taxes and will deduct the amount due from the sale proceeds.

Sell a portion of the shares to cover costs and hold on to the rest. You can exercise and sell enough shares to cover the cost of the option, transaction costs and any taxes due. You then hold the remaining shares, expecting that the price will rise over time.

Exchange lower priced stock in the exercise. This strategy involves a trade-off. Some plans permit the option holder to meet the exercise cost by exchanging shares you already own (using the market value of these shares). This allows you to avoid the use of margin debt or cash to facilitate an exercise without having to sell low cost basis shares to do so.

Geraldine D. Leder is principal and manager and William B. Boyd is managing director of BT Alex. Brown's .Corporate & Executive Services Group.

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