As we mentioned in our “Crash Course in Startup Stock Options” post, startups often offer stock options in lieu of market rate compensation. Say you’re employee number 5 at Snapchat, those stock options are worth far more than you could have dreamed to make in salary alone at your average company. This is the scenario that enables startups to attract and retain quality employees who have a vested interest in the growth and success of the company.
However, if you are to leave the company and exercise your options, you have to deal with the logistics and financial implications… and by financial implications we mean taxes. Yes, taxes are inescapable, but an understanding of how taxes on stock options work will help you make smart decisions, and hopefully, make taxes a little less painful.
When Are You Taxed, and How Much?
It’s all about timing when exercising your stock options. First, determine whether your options are Incentive Stock Options (ISO) or Nonqualified Stock Options (NSO). Most companies offer ISOs with a typical vesting period of 4 years and a 1 year cliff. In a 4-year vesting period you have access to 25% after year one, 50% after two years, and so on. Once you are fully vested, you have the option to sell your stock or hold onto it and wait for the value to increase (in most cases).
When you sell ISO taxes, your gains will show up in an Alternative Minimum Tax (AMT) calculation. Gains are the difference between the strike price and the Fair Market Value (FMV) at the time of exercise. For taxable income up to $175,000, the AMT tax rate is 26%. Gains below $10,000 are usually not a large enough amount to push the AMT, and you will not be taxed more than the normal amount.
Here’s where it gets a bit more complicated. If you do not to sell your stock immediately after exercising because of current FMV or any other reason, you’re subject to different taxation rates based around a 1-year period. Selling before the calendar year of exercise shifts you to a non-qualified disposition, and if the FMV of the stock is lower you can regain some of the taxes you paid as the AMT excess becomes a minimum tax credit (MTC).
If you sell after the calendar year of exercise, but before two years then you do not have the option to receive credit from taxes paid on the previous FMV. However, if the FMV goes up, you’ll pay short term capital gain taxes(same rate as your income) on the difference between FMV date of exercise and sale.
After two years, you have relinquished credit options on previous FMV taxes. If the FMV goes up, you’ll be taxed for long term capital gains(usually around 15%) on the difference of FMV at date of exercise and date of sale.
What Are Your Choices?
The catch is, most employees have only 90 days after they leave a company, or are terminated, to exercise their options. The status quo puts employees in a tricky situation. Often the strike price and the ensuing tax bill is more cash than employee has available, and they have to choose between leaving their vested options or being stuck at the company. You can choose your options sooner in order to pay less AMT taxes, but that’s a bit of a gamble on the company’s future success. Conversely, the value may go down and this would leave you with a capital loss.
One of the best solutions to benefit employees is to extend options past the usual expiration. Pinterest recently rocked the boat, offering their employees of at least 2 years to retain their options without exercising for 7 years. This model affords employees the benefit of time to find out if the company goes public, is acquired, or doesn’t make it in that time frame. This way, the employee will have the funds to exercise, or know if the funds were never worth exercising if the company doesn’t make it. Most importantly, this doesn’t tie you to a job you’re not happy at in the name of stock options and potential tax hell.
Giving employees RSU (restricted stock units) instead of ISOs is another way to avoid the funds and taxation problem. RSUs are because they always hold value when they vest, and are turned into stock at FMV. RSUs and NSOs are taxed like normal income, therefore removing the burden of the AMT tax calculation associated with ISOs. However, RSUs would be continuously taxed after the initial grant.
Perhaps employee stock is simply outdated and in need of a new option. Shares that are both cheaper and hold less rights may be the solution. If it were possible to create a class of stock that the IRS agreed had next to zero value, you would only owe a miniscule amount of taxes now. At an acquisition these stocks would be converted to common, and if the company goes public years later you could be setting yourself up for attractive capital gains.
In a perfect world, the IRS would leave illiquid private stock alone until sale, and then treat it like normal income. There are hopeful solutions out there to remedy some of the issues with the standard exercising and taxation policy. In the meantime , our understanding of timing and choices helps make informed decisions to benefit your career and bank account.