Employee equity and tax Q&A’s: How to avoid the ISO/AMT trap (“golden handcuffs/golden bullet”), and more

For advanced readers. Assumes basic knowledge of ISOs. Disclaimer — not a lawyer, accountant, no certification, this is not legal or tax advice. Just an employee working in a complicated world where information is scarce. An average Joe wanting to help others get screwed, since he’s seen it happen before.

Situation: You are fired (or otherwise leave a company). You hold Incentive Stock Options. You can’t afford to exercise them AND pay the taxes, specifically, the Alternative Minimum Tax. You have 90 days or you lose your shares forever. What do you do?

Solution: There are many liquidity options to help you pay the tax-you’ll sell enough shares until you can afford the AMT, and hold the rest. These come from either friendly (company) or third-party (independent financial firms). This still works even if arguably legally toothless wording discourages those options.

If you can’t find takers or want a homegrown solution, you can still exercise, then do a sale in the same year (at ANY price) to a friendly party, to prevent AMT from taking hold. This can take the form of a real sale/forward contract/constructive sale, or even a bargain sale to a charity. You can then buy it back later. You can rarely be totally screwed by AMT unless you exercise and don’t act by December 31 in the same year of exercise.

Outline:

  1. Introduction and background
  2. Scenario
  3. Solutions
  4. Secondary market solutions
  5. Private/potentially friends and family deal solutions
  6. Liquidity in general
  7. Shareholder agreements and legality
  8. Common questions

Introduction and background

Many employees are vaguely aware of options, taxes and AMT. Unfortunately only a significant minority have investigated it and the scenarios deeply, something that gives employers more power and disadvantages employees.

Even fewer truly understand AMT and the various shapes it takes when exercising and then trying to get back credits e.g. getting long-term tax rates. This comes from dearth of education, the extreme tax complexity of the tax code, the rarity of the situation, and the taboos against speaking about equity. Fewer still know about alternate liquidity options. And the smallest pool is those who know the most about how exactly all scenarios can work and can operationally pull it off.

As someone who acquired all the somewhat obscure knowledge, I’d like to share it. I recognize I’m not in a unique scenario when it comes to much of the basic facts regarding taxation. But the compilation of all the various liwuidyt choices and logistics is something I’ve rarely seen online. This comes from working at two private companies that issued stock options, and mulling over the tax consequences heavily many times for myself and various friends who have chimed in.

For more basics/primers, EquityZen’s excellent series of equity explanations or Wealthfront’s are great. (warning on Wealthfront’s item: some items such as the ultimate tax result are mostly correct but not that accurate, especially AMT credit scenarios, but that is for another post.)

Scenario

A common scenario that an optionholder faces when at a private company is: what if I need to exercise e.g. buy my shares, before I lose them after 90 days of leaving or being fired? How can I do that without being killed by AMT assuming my company is not private and I have a significant value of stock. A common scenario may be: being fired or leaving before a liquidity event.

It used to be that either (a) you could sell it on the secondary market or (b) most likely you’d often be public by then. However, as companies stay private longer and longer, and now increasingly add very legally dubious language not just having a right of first refusal and share repurchase, but ALSO prohibiting share transfers outright, AND claiming they can also prohibit any loans or transactions.

Such tertiary restrictions essentially have very little teeth when you are no longer an employee: many lawyers have weighed in and hinted that these are basically unenforceable, and such an employer would likely lose in at least (1) the court of public opinion when word gets out (2) likely lose legally, given that the company cannot actively sue for damages. One of the reasons for restricting transfers is ostensibly to keep the cap table under 500 people to avoid reporting requirements, which is very fair, but when companies start adding these tertiary restrictions e.g. on loans or other items to try and restrict employees, OR even worse to try and claw back EARNED and vested equity from former employees they’ve decided to fire, that is bad. I’ll offer some AMT calculators in future posts.

So, what exactly is the problem? First, is a very questionable tax treatment of ISOs that traps employees. The various scenarios are (1) you can afford both the exercise price and AMT (awesome)(2) you can afford to exercise, but not the AMT (likely if your options have a relatively low strike price e.g. you joined at least one fundraising round ago) (3) you cannot afford either to exercise nor to pay AMT.

To approximate your AMT burden, multiply 35% (28 fed, 7 CA) by the price difference between today’s FMV/409A valuation. You also need to take your strike price too to find your total cost. (ignore the effect of exemptions — they’re usually only good for $30–50,000 AMT Income at typical $120K+ engineer salaries, which your equity grant likely exceeds — it’s always possible to exercise SOME but very little options before triggering AMT)

Common scenario A: Joined very early, exercising is not so bad, but taxes are impossible. You are granted 50,000 ISOs with a strike price of $0.10 each when you join the company (the 409a was $0.10 a share then, the preferred price/final valuation say $0.40 a share). Your company is now much larger and the the 409a is about $20 a share, closer to the last raised private round of $30 a share. Congratulations, you’re a paper millionaire. But suddenly, you receive the dreaded email from HR. You’re fired. Your company is private. And now you have 90 days to exercise or else you lose everything. It’ll cost you $5,000 to exercise, but the AMT liability will be about $350,000 (subtract a bit for exemptions). No way you can pay that come April 15 next calendar year.

So, how do you get around this?

The easy solutions

Isn’t life great when people decide to help you? The company may, like many others, be offering to extend the exercise windows. You have to determine how employee-friendly your company is. Your ISOs will convert to NSOs, you’ll lose some long term gains, but whatever. If you are offered this, TAKE IT. The company may buy back your shares, perhaps either all, or enough to cover AMT. It will almost always be at a worse rate however.

Harder solution: Secondary market and tax calculations

Second, the institutional options. This will require more work, obviously.

  1. Structure A: They offer a loan upfront to exercise and pay for AMT, but ultimately a sale structure where they take a significant amount of your upside. Examples: ESO Fund
  2. Structure B: Outright sell enough shares on the secondary market to pay for your AMT bill. Through services like EquityZen, Equidate, and unnamed others, they will match you with buyers.

Let’s assume structure B, as it is easier to understand and a more common market than structure A, which is primarily done by one company it seems (ESOFund):

You’ll generally want at least $100,000 of equity to pursue the latter option smaller chunks are less likely to be bought, and deals take time to make. What are the pitfalls?

  1. Once the other side know you’re in a precarious situation e.g. got fired, need liquidity, goodbye negotiating leverage.
  2. Fees are expensive — likely 5–7% broker fee on the smaller transactions, plus 3–5% legal fees since you SHOULD get your own, good lawyer.
  3. Your price will never be as good as the last preferred round usually, often 5–20% worse, depending on investor demand and your company.
  4. You need someone on the other side to always BUY your stuff. In case 1 e.g. ESOFund, they always could, but in case 2, you’re on the hunt. If they sniff out a particularly desperate buyer or a particularly undesirable company, you could take as much as a 50% haircut, or NO ONE may be willing to buy.
  5. Equity that is more valuable/likely to work on the secondary market is typically stage private companies likely to have an exit on the horizon, or has sufficient secondary interest. Equity at a random series A or series B startup is far less likely to have a secondary market
  6. Many refer to these companies as somewhat “loan sharky” — they find people in a desperate situation and they offer them a tough deal. The lower demand your stock is, the worse. You likely will have to give up the majority of your upside on the future of the stock e.g. you own 40% of the future gains, they own 60%, in order to get the cash upfront. Better than nothing, but keep in mind as long as you involve a third party, the third party will make money.
  7. If your deal is small enough, and you can mostly afford the tax out of pocket, all the various fees and hassles above likely mean your return on paying the tax yourself is likely better. Let’s say you have a net worth of about $50K from some savings, and of that, you have $20K in the bank and $30 in investments. We can use portfolio theory to explain this too if needed. If your total AMT liability is $20K, even though you’re now investing this in a tax benefit, the likely fees and above issues means you’d give up/pay immediately 30–40% of the value of your shares by doing this deal, you can invest the 20K now, get 5K AMT credit back per year (25% return) and earn another 40% value by not paying secondary market fees. OTOH, if you owe $200K AMT, you pretty much need to use these options. See end for AMT calculations, especially because getting AMT back is slow.
  8. If you are forced to use a forward contract since you must do this without company knowledge, expect to take another 10–15% price hit. Buyers much prefer the safety of a full, physical share transfer.

So, you had shares you thought you could sell at $30 each (private valuation). But ultimately after a 10% legal fee, 5% transfer broker fee, and 35% discount on the secondary market, you only get 50% as much. So you sell 23,000 shares at $15 a share to raise $350K to pay AMT.

Now let’s calculate your regular tax and AMT for this year, and see what you need to pay.

By selling, you’ve triggered a taxable event in regular tax realm. Selling your shares short term means you realize a ($15–$0.10)*23,000=$342,700 gain.

Will that trigger enough ordinary income to increase your overall taxes?

Your AMTI for this year will be ($20–$0.10)* 27,000=$537,000 AMTI for exercise/hold PLUS $342,700 short term gains = $879,700 AMTI. Federal, you should pay about $245K, and $61K in California for $306K total (approximated using 28% and 7%).

Now, let’s calculate your regular tax liability: You made only $342.7K in the regular world, since only the short term sale of 23,000 options is taxed, not the 27,000 exercise and hold. You will owe about $30K CA state tax, and $86K federal (deducting $30K state against CA). Since in both cases your AMT is higher than your regular tax liability, you’ll pay the total $306K tax.

Calculator in a spreadsheet coming later.

Final result:

Timeline: I will come up with another post for the exact logistics for transactions.

May 1: No longer with the company. 90 days e.g. until August 1 to exercise.

May 2: Reach out to secondary market deals above

May 9–10: Secondary market brokers will contact their list of investors and find potential buyers.

May 11: Secondary market broker finds a potential buyer.

May 15: Begin reaching deal with a buyer

May 16: Additional documentation needed e.g. stock certificate, equity grant documents, potentially 409a

May 19: Depending on secrecy needed, either (a) secondary market broker reaches out to company and either gets accepted or (b) right of first refusal pulled, or (c) never reaches out

June 1: 50,000 ISOs exercised ($5000 paid out of pocket)

July 1: Close the deal. Receive $343K cash for selling 23,000 shares. You continue to hold 27,000 shares.

December 31: Tax year ends

April 15, next year: You now owe approximately $310K in taxes.

Common Q&A: Don’t you have to account for paying short term gains on those 23K shares before you can pay for AMT? No, this is the same tax year, so actually your AMTI still stays well above ordinary. Think: we started this approximation with 100% exercise/hold, which triggers AMT, but once we start selling, we recognize less AMT income, and more short term regular income. Calculation later.

So, at the end of all this ordeal, you now can hold on to your remaining 27,000 shares and sell them for long-term gains. But now, given your ability to sell now, wouldn’t you do more — or potentially all? That really depends on if you believe in the company or not. You can also try to determine if you should hold on to your shares for that year and sell again to get long term gains (The general “tax alpha” for long term gains given a very low e.g. $0.10 cost basis is about 30% — for what that means in your portfolio, we can analyze using modern portfolio theory to give a result — see other post and calculator). If you have to sell, or if it’s a private company you think will do well, you can be well advised to hold this, although most evaluations of modern portfolio theory, depending on your risk tolerance, would rarely advise a huge net worth holding in a private company. If you need to do a transaction now, why not sell even more to take more off the table?

If the 409a is roughly the same as the private valuation, expect to sell about a third of the shares to cover AMT(rough approximation).

So, that was complicated.

What if none of the above are takers, or you are just a paranoid person who wants yet another line of defense, or just don’t want to deal with these third parties?

Most creative solutions: Private and homebrew

Here’s another option I’ve researched and determined should work. Well, it’s the same as above. You don’t need to sell to a secondary market broker. You can sell to anyone!

Let’s say though, that the market for these shares is obviously a lot shallower. What if, though, there’s an implicit or explicit agreement they can sell it back to you, or you will get it back later, and this disposition is to avoid insane tax? You can draft a forward contract to do this too.

Another structure is to find a person with the SAME stock, and perform a market-value buy/sell of these. You’ll both experience taxable events, but at least the act of disposing of them will save you from the AMT trap. That’s really the main issue here.

But wait, won’t the IRS cry foul? Well, the worst they can do for a non-charity is to determine that the amount sold below fair market value is a gift. And even then, these bargain sale rules almost always only apply to related people, so avoid say your immediate family or corporations where you hold a majority interest. So let’s say you sold the stock $2 a share to a friend — by writing a forward contract in which the shares will definitely be delivered in the future-then this counts as a constructive sale, and a disqualifying disposition, meaning no AMT, but you do see ordinary income. Under provisions of the tax code, if the gain realized from the same-year disqualifying disposition of an ISO is less than the FMV, then you will be taxed at the maximum of that realized gain. So, your tax for this year is $2*50,000 = $100,000 * 45% = $45,000 or so on this income. But you will have no AMT.

Another thing I am thinking of is, well, why not just buy it back from the other person within the same tax year? This isn’t taking a loss, so it’s not a wash sale. Seek an accountant on the appropriate structure here. If you did two forward contracts, one to sell to a third-party at $2, then one to buy it back even after say 5 months at $3, then you’d owe taxes of $45,000, but at least you saved yourself from AMT.

So, the IRS then sees the below-market value trades. Where does the gift tax rule comes in? It’s possible that if these are ruled as bargain sales, you will incur a gift — but individuals have a $5 million gift tax lifetime exemption (meaning you won’t pay tax! but if you ever die with more than $5 million, your kids will be able to inherit less without taxation), and couples have $10 million. Given that our main goal is to avoid a strangling AMT liability, taking the gift is fine. You also have a $14k yearly exclusion, but that’s relatively negligible.

The gift tax owed would be the difference between the FMV ($20) and the price point of the trade ($2). You may be forced to then recognize a gift of ($18 * 50,000 = $900K) if the IRS deems that this is too much of a bargain sale. Notice that you don’t pay any taxes on that $900K now, unless you’ve somehow managed to gift more than $4.1 million already! It’s much better to now only be able to pass on $4.1 million vs. $5 million in the future, than be hit with a massive tax bill today. And if you already had a $10 million worth today, then you could easily pay the AMT in the first place, noting that the loss of $350K is less than the gift potential losses of say $450,000 assuming 50% estate tax rate — HOWEVER, given that you’re going to wait the rest of your lifetime to make up the gift tax, it is likely better to take the cash today).

What if, say you wanted to just still completely own the right to these shares? Well, you could create a corporation that own, that you’d sell to via contract, and then sell back. Since it is a related party, you’re forced to recognize a bargain sale and to get hit with gift tax. This is where it gets murkier and creative accountant types can chime in.

Note that you can also do a constructive sale via a bargain sale to a charity, so you could create a charity rather than a corporation, but that comes with a lot more restrictions on what the funds can be used for, obviously.

Why can’t you just directly donate to a charity, related or not? Note that when donating appreciated stock (your basis is $0.10, the FMV is $20), you still recognize the $19.90 gain this year as income (since you didn’t *sell* at a different price), but when you donate, you can only write off the $0.10 basis, NOT the $20 FMV, because you must exclude any gain that is not long-term capital gain from what you can write off.

Liquidity in general

So, if I can get early liquidity, shouldn’t I exercise as many as possible even if there’s an AMT hit, sell some shares to cover the AMT, and start the long term tax clock ticking? Basically, given the inefficiency and difficulty of the secondary market, I don’t think it’s worth it, BUT often times you can justify it with diversification, however, the -EV from say firing (the main recourse for violation of any share restrictions) would be a huge risk that should outweigh everything else. So the long-term tax gain is often usually effectively 30–40% (50% short term vs. 30–35% long term, you must compare the final proeeds e.g. sell $100 worth, get $50 from short term, get $65–70 from long term — and AMT issues is often why the long term is not fully 20% better-explained in another post).

This is not insignificant. However, there are also significant suspicions. A worry is that exercising a large chunk of your shares while still working at a company, then potentially following up with legal to get other information, could easily trigger the questions of the legal team and potentially prompt investigation. There’s very little way for them to find out, but the common way to retaliate obviously, is firing, since you are likely an at-will employee.

A large part of the ability to use the above plans, doing things against your company wishes, is that enforcement mechanisms besides them firing you is very weak. Using game theory, however, you often take a 20–30% hit from doing this (5–7% transaction fees, 3–5% legal fees on the deal, 10–15% worse price on the secondary market than the last preferred valuation), so you’re really only left with a ~10% gain from this. If you’re say, halfway vested, there is still also a slim chance the company could find out, you could have significant action taken against you — firing, and that slim chance, if it happens even 5% of the time, costs you 50% of your equity, and the higher simple risk factor is bad. However, it will be a very good time to test the legality of some of the extremely onerous share restrictions in court.

Shareholder agreements and contracts, commentary on the marketplace

First, let’s consider the typical employee equity agreements and the restrictions

  1. Right of first refusal: Any sale by you must be presented to the company first, who can then decide to buy the shares on their terms. Depending on the wording, they usually have to offer you the same price as the buyer
  2. Right of repurchase. They can simply rebuy your shares at any time, exact value varies too (sometimes FMV/409a, rarely the preferred price)
  3. Outright prohibition of any sort of share transfer without board approval. Rarer but becoming more common. If not in your option agreement, then you can proceed without this.
  4. Outright prohibition of any sort of share transfer, as well as any loans or transactions otherwise based on the shares. Almost guaranteed to be unenforceable in court of law (company damages minimal), but only and powerful mechanism of enforcement is by firing employee. But if you’re already fired or no longer work there, there is nothing to fear. These are often not even in the equity agreement itself, which means it is not something you signed nor agreed to, but a scare tactic from legal that sometimes is hidden elsewhere in a different rule book, and even if it is, it likely would fail in court or otherwise violate Delaware shareholder rights once the stock was exercised and received, it is yours. The company doesn’t have to transfer its recordholder, but how can they find a random mortgage or lender and claim damages because you did a contract based on it?

How should one approach this situation? Well obviously, the best deal is still done with company approval. It is never in your interest to seek out direct contact with the company, instead, the outside broker will do so to get approval. If it works, then great. If they exercise the right of first refusal, that’s fine, YOU will still get your money, even if the other buyer does not. This is if they exercises clauses 1/2.

If you get option 3 thrown at you, you simply proceed with a forward contract. If you get option 4 thrown at you, same thing. The company has no ability to find out a completely separate economic agreement between two other parties, and short of extreme pressure, hacking your email, or otherwise accusing without any evidence, they cannot reasonably take action. They simply rely on employee fear and intimidation to keep people grounded (and for the vast majority of people, the ability to fire current employees and make them lose their remaining equity).

If you are afraid of a lawsuit, here’s a bold offer: Mr. Equity will gladly offer anyone who is involved in such a suit to pay $20,000 and potentially more of their legal fees. He is doing this out of a stand of principle. These unenforceable and unconscionable attacks on shareholder rights should be shown to lose in court. This will do all employees and the entire startup community a huge public service when, once and for all, these relatively new restrictions are shown to be invalid.

I recognize that many may not want to be the martyr and tar your name in court, but the offer stands. We need bold people to take a stand and change the culture for the better. More robust secondary markets, and the inability to lose everything when fired due to obscure tax provisions, are a win-win for everyone. Except for wrong-headed management who feels that “retention” should justify all these evil deeds.

Most of this information is hidden in various places like random blog posts, journal entries, and hacker news comments.

Commentary on the broader ecosystem

Working at a private company means you do not have the benefit of “Let’s sell this on the NASDAQ” at a public company. A lot of employees like me at earlier companies nowhere close to a public offering or acquisition are in difficult dilemmas. The classic “golden handcuffs” scenario, or the “golden bullet” in the case you are fired. Several entrepreneurs and VCs like Mark Cuban and Fred Wilson have encouraged companies to go public. However, public shaming rarely works. Many private companies choose not to, given that they have more leverage over employees and fewer reporting requirements.

This reduces the turnover of employees, and while “could” be good for companies, makes the ecosystem worse, preventing exits like PayPal from spawning the PayPal mafia, and generally slowing the pace of innovation and freedom. All due to a simple, obscure tax provision called the ISO spread. We’re still not at a stage where the average employee knows enough to take action here.

They’ll often make a thought of leaving to do something else, and then immediately be hit by warnings from friends and accountants about AMT, not knowing all the options at their disposal. Or they’ll have a timid, 10-second conversation with the company’s legal team, who does not have THEIR best interest at heart, but rather protecting the company, and not realize that they have so many ways to break free. And thus, another inefficient allocation of a person, and another victim of the tax code. Probably only 1 out of 5 or 1 out of 10 employees who are fired ultimately end up doing one of these more bold moves

Some tech companies have gone public, or planned to and got acquired, but many small and large alike will likely remain private for years to come. Only a small cadre of people ever have to THINK about this simply because (1) well, who likes thinking of taxes? (2) it’s really complicated (3) things change swiftly, and it takes a lot of work, research, to get to this stage. Many of these financial products and strategies are new, novel, and often operate in relatively non-transparent worlds.

Common questions

It’s OK to owe some AMT, right, because you can get it back in the form of credits? Yes, if the scale is small enough (<$20–30K), no, if the scale is much larger, which usually drives these problems.

Using a calculation of $100K income in California, single, no dependents, no mortgage interest deducion, only state tax deduction, you could get about $9–11,000 AMT credit back per year. Making $130K, you’d get about $6,000 credit back per year. Making $200K, you’d get about no credit back. If you make nothing, you won’t ever get AMT back because your AMT liability and regular liability is the same e.g. nothing, and if you make about $50K, the total amount of tax you have is insufficient to make it back.

I asked my local CPA and they have no knowledge of the secondary market nor these fancy terms? Only a few hundred or so year are really in this situation. And most CPAs do not deal with super intense Silicon Valley style tax situations. In this case, no offense to them, but their expertise is not worth it. Find a firm that works extensively with people in this scenario. Many barely understand how AMT work, or just assume that you can get your credit back really easily (yeah right, if you have $250K credits, it may take you until your kids are grown up and off to college)

Feel free to reach out with questions.

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