According to reports, more employees bought company shares via employee stock purchase plans during the pandemic.
Offering employees company shares as part of their compensation package is common among startups. Not only can it boost employee engagement and further startup success, but it can also turn into a lucrative opportunity for employees.
However, there are some things to consider when it comes to stock options. If you don’t watch out, you might land up with a hefty tax bill you didn’t expect. In some cases, the tax implications can be so high that employees end up forfeiting their stock options completely.
Are you receiving company shares as part of your compensation package, and are wondering what it means to exercise your stock options?
Continue reading to find out what’s involved in exercising startup stock options and how to manage the tax implications.
What Are Employee Stock Options?
If you are unfamiliar with employee stock options, let’s quickly define what they are.
Stock options are contracts that give holders the right to buy a specific number of stocks at a pre-set price. Stock options are used widely in trading, where a trader or investor can purchase stock options. This is known as options trading.
Employee stock options work a little differently from market-traded stock options.
Employee stock options are issued by companies to employees as part of their compensation package. This gives the employee the opportunity to consistently accumulate equity in the company over a set period of time.
If you accept stock options as part of your compensation package, the options aren’t usually given to you all at once. Instead, they are “vested” to you on a regular basis over a certain number of years.
In other words, the stock options are granted in increments.
For instance, let’s say part of your compensation package is 2,000 stock options. You might receive the first 1,000 in the first year of employment, 500 in the second year, and 500 in the third year.
What It Means to Exercise Your Stock Options
Once stock options are vested to you, you still don’t own the actual shares. Instead, you own the right to buy the shares at the pre-set price.
The act of buying vested shares is called exercising. You are exercising your right to purchase the vested shares. In other words, exercising your stock options means buying your vested shares.
If you don’t exercise your stock options, at some point they will fall away. For instance, most companies require employees to exercise their stock options within 90 days of leaving their positions.
ISOs vs NSOs
Before we get into the tax implications of exercising your stock options, it’s important to get clear on the difference between incentive stock options (ISOs) and non-qualified stock options (NSOs).
NSOs can be issued by any company and vested to any service providers, including employees. When you exercise NSOs, you will need to pay federal income taxes on any difference between the exercise price and the fair market value of the shares.
Unlike NSOs, ISOs can only be vested to employees and only by entities taxed as corporations. ISOs are usually a better option for an employee because it comes with some tax perks. However, there are also some requirements and restrictions around these.
The primary benefit of ISOs is that you won’t incur federal income tax when exercising (if you meet the requirements). If you hold the exercised shares for the required period, any profit you make on the sale will be taxed at capital gains rates.
However, these tax advantages only apply if:
- The fair market value of the shares you receive that are exercisable in one year does not exceed $100,000 (this is based on the fair market value at the grant date)
- You exercise your shares within 10 years of the grant date
- You hold your ISOs for more than two years after the grant date
- You hold your shares after exercising your stock options for more than a year
- You exercise your shares three months after employment termination
If you receive more than the maximum value of exercisable shares within one year, any excess will be treated as NSOs for tax purposes.
Tax Implications of Exercising Your Stock Options
On the surface, exercising stock options is pretty simple. However, the tax side of things is a little more complex. It’s essential that you understand what the tax implications are of stock options, otherwise, you might end up paper rich and unable to handle the tax costs of exercising.
If this happens you run the risk of having to forfeit your stock options.
Here are some of the tax considerations that you need to think about before exercising your stock options.
Income Tax
The first type of tax that you may incur when exercising stock options is income tax.
As we outlined above, ISOs are not subject to income tax at exercise.
If you exercise NSOs, you will need to prepare yourself to pay federal income tax on the difference between the pre-set price of the stock option and the fair market value at the time of exercising.
For instance, if the pre-set price per share is $0.50, and the fair market value has risen to $1.50 per share by the date you exercise your stock options, the difference will fall as part of your taxable income.
Let’s say you exercise 1,000 shares. If the spread on these is $1 then your taxable income will rise by $1,000.
If the company shares have appreciated substantially since your stock options were granted, the income tax on this could be sizeable. What’s more, because you don’t gain any liquid cash from exercising, just ownership of the shares, meeting this tax liability can be tough, especially if your company’s stock option plan restricts you from selling right after exercising.
If you don’t have the cash flow on hand to cover the tax liability, you might be forced to give up your stock options entirely.
This scenario happened to one tech worker, who was no.4 worker at a startup. When he resigned, he had $50,000 set aside to exercise his stock options. However, HR then informed him that he was also due to pay roughly $1.8 million in income tax upon exercising.
With only 90 days to raise the money, the Wouter Witvoet ended up losing his entire equity stake.
This is just one example of how even a well-prepared employee had to give up their stock options thanks to tax implications.
Capital Gains Tax
Capital gains tax can apply to both ISOs and NSOs if you sell exercised shares.
For ISOs, capital gains tax applies to the spread between the pre-set exercise price and the fair market value at sale. For NSOs, capital gains tax applies to the spread between the fair market value at exercise and the fair market value at the sale of the share.
The reason for this is that NSO holders will already have paid income tax on any appreciation that happened between the grant date and exercising their stock options.
To get an idea of how capital gains tax plays out for ISOs and NSOs, let’s take our above example one step further.
ISO example
If you exercised 1,000 ISO shares with an exercise price of $0.50, and then sold them after 3 years for $5 you would need to pay long-term capital gains tax on the $4,500 profit you made.
NSO example
On the other hand, if you had NSO shares, you would only need to pay capital gains tax on the spread between the fair market value at the time of exercising and the sale price. If you exercised 1,000 shares when the fair market value was at $1.50 and sold the shares three years later for $5 per share, the taxable amount under capital gains would be $3,500.
AMT Tax
Another tax type to keep in mind when exercising your stock options is AMT. AMT stands for “alternative minimum tax“.
If you are filing as a single person or the head of a household, the earnings threshold for AMT is $73,600. If you earn more than this, you might be subject to AMT, however, it’s not a given.
AMT is a complicated tax type. Not only is it tricky to figure out whether it applies to you, but it can also affect your taxes in complex ways. It can disqualify you for various tax breaks, including deductions like:
- The standard deduction for personal items
- Deductible medical expenses
- State and local taxes
- Home equity loans
- Real estate property taxes
ISOs are one of the things that can affect whether or not you fall into the AMT bracket. If you exercise ISOs and hold your shares, you will receive Form 3921 in January. You can then calculate whether or not you owe AMT.
Fortunately, AMT is not as bad as many people assume. With AMT, you’re essentially pre-paying taxes that you can recoup at a future date. Once your regular taxes exceed AMT, you can use your AMT tax credits to offset levies.
If you do not want to trigger AMT, then you should consult with a tax professional to find out how many of your ISOs you can exercise per year without crossing the AMT threshold.
When Should You Exercise Your Stock Options?
When it comes to tax and stock options, one of the most important considerations is timing. Badly timed stock options exercising could land you owing extra money to Uncle Sam and realizing a poor return on your equity investment.
On the other hand, good planning and timing could allow you to avoid a crippling tax bill, while simultaneously seeing handsome gains on your shares.
Nobody holds a crystal ball, therefore gauging your timing around exercising stock options can be hit and miss. However, if you inform yourself of the tax implications, and make a calculated decision, you’ll be in the best position to enjoy less tax and potentially more returns on your money.
Here are some of the different times you might choose to exercise your stock options and the pros and cons associated with them.
Exercising Early Through an 83b Election
Some companies allow for early exercise of stock options via an 83b election. Exercising early through an 83b election has a few advantages if you have NSOs. Firstly, it can help to reduce your taxable income.
If you exercise at the grant date, you get the opportunity to buy all your shares before they appreciate in value. If you wait until the shares vest, the fair market value might go up. With NSOs, you will then need to pay income tax on the rise in value.
Another advantage of exercising early is that you can start the clock ticking on your holding period. If you sell your shares after holding them for a year or more, any gains you make will incur tax at long-term capital gains rates rather than short-term capital gains rates.
Early exercising through an 83b election is not as advantageous for ISOs as they don’t trigger income tax. Also, if you hold ISOs, early exercising won’t necessarily bring forward the start of your holding period. Instead, it will default to the date of vesting.
However, you can choose to add the “income” from early exercised ISOs to your income under AMT. If you are bound to enter the AMT tax threshold through exercising your ISOs, choosing to exercise them early can curtail the amount by which you exceed the AMT threshold.
Exercising Your Stock Options Later
Early-exercise options aren’t always the best route. If you hold ISOs, you might want to wait until the stock has risen. This way you can be sure that you are making a smart buy.
However, keep in mind that if you want to avoid short-term capital gains tax, you will need to hold the ISOs for three years before selling the stock. There is always the chance that during this time the stock value goes down.
Exercising in Anticipation of an IPO
One of the common times for people to exercise their stock options is in anticipation of an IPO. IPOs can be the catalyst for substantial rises in stock value.
However, be aware that a lot of companies will place certain restrictions on the sale of exercised shares directly after an IPO. There might be a mandatory holding period.
Thinking About Exercising Your Stock Options? Get Professional Tax Planning Help Today
As you can see, there’s a lot to consider before you exercise your stock options. If you want to avoid unpleasant tax surprises, the best thing to do is speak with an accountant or tax planner.
Looking for someone to help you plan how to mitigate the tax burden of exercising stock options? Here at Pasquesi Partners, one of our specializations is accounting and tax planning for startups. Contact us today for professional tax planning help for exercising your stock options.