Stock Options and Taxes Simplified

Disclaimer: I am not a tax professional. Read at your own peril.

Congrats, now you have stock options in a hot startup. These are hopefully going to be worth a ton of money one day, so it makes sense that you want to figure out the tax implications. If you’re still really confused after the tax accountants presented (let’s be honest, you didn’t pay attention) and after googling around, I was there too, and this is the post I wish I had to break it down for me. Why should you care? One day your stock options are going to be worth a lot of money right? 20% of a lot of money is… a lot of money. And you could potentially save that amount in taxes. Lastly, note that I’m leaving out a ton of nuance so please ask your tax professional if you want to really optimize for less taxes on your options.

*Edit from Feb 2016: note that there’s absolutely a ton of risk here of losing all your money spent on early exercise if your stock ends up being worth less than your strike price.

The key thing is: There are 2 events where you may get taxed before your options convert to cash: 1. when you exercise your options and 2. when you sell your stock.

1. When you exercise your options

You need to exercise your options to get stock so that you can sell the stock to get cash. [1]

As an employee, you can receive Incentive Stock Options (ISOs) or non-qualified stock options (NSOs). You probably have ISOs.

Exercising ISOs is technically not a taxable event, but you are almost certain to incur Alternative Minimum Tax which is going to be taxed at (current fair market value - strike price) * AMT rate (28%). You may have to pay less than this or can avoid this depending on what other fancy tax stuff you’re doing that year e.g. mortgage interest. You should consult your tax professional for how to optimize for AMT.

Exercising NSOs means you have to pay: (current fair market value — strike price) * income tax rate.

2. When you sell your stock

Now that you’ve exercised your options, you have stock to sell for cash. You can sell stock for cash when the company is public and the lockup period is over (usually 3–6 months after IPO), or in some secondary offering of private stock by your company, or if there’s an acquisiton. Acquisitions are trickier, but the gist is that all options/stock you’ve vested will either become the acquiring company’s stock and you may get taxed on that gain, or it becomes cash and you definitely get taxed on that gain. [2] [3]

You get taxed at either the short term or long term capital gains rate when you sell your stock. Short term capital gains are taxed like income. Long term capital gains are taxed at a rate that’s around 15–20%, which is about half of short term capital gains which are taxed like income.

You get taxed at the short term capital gains rate unless you sell stock at least 1 year after exercising and 2 years after grant.

You get taxed on tax rate * (sell price - exercise price) e.g. if you exercised your stock which had a strike price of $10 at fair market value of $20, and sold them for $100, you most likely only get taxed on the $80 not $90. Here’s more details on when you may get taxed for $90.

What this means

If you can early exercise [4] when fair market value is the same as the strike price (i.e. within the first year or less after you join the startup), and you believe the stock will be worth something, and you have enough cash to do it, you should early exercise because you can avoid taxation on 1. when you exercise your options, and start the clock early so you get long term capital gains treatment for taxation on 2. when you sell your stock.

Now that you get the basics, consider reading a more nuanced viewpoint so you can’t blame me when your hot startups’ stock is not so hot one day.

Lastly, it’s worth keeping in mind the fact that getting taxed a lot because you’re going to make a lot of money is, in many ways, the ultimate first world problem.

[1] If you’re wondering why you can’t just sell your options for cash directly, it’s because your employee stock options are non transferable.

[2] For options you haven’t vested, it’s really up to the acquirer, but most likely they’ll convert them to some new golden handcuffs for you i.e. new company stock that vests over longer period of time.

[3] Regarding whether you get taxed upon acquisition, it can vary a lot depending on the terms of the deal.

[4] Not all companies will allow you to early exercise unvested shares; most allow only for vested shares.