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Step by Step Guide to Planning for Early Stock Option Exercise

Early Stock Option Exercise

Planning for Early Stock Option Exercise can be overwhelming and challenging. if you are one of the many employees of early-stage startups and private companies who receive equity compensation in the form of stock options and RSUs., this article will give you a starting point.

Planning for Early Stock Option Exercise

You probably want to understand how owning stock options will impact your long-term wealth.  The exact specifics of your equity compensation will vary widely from one company to another. There is also a vast range of possible outcomes regarding the value of your equity and the timing of your liquidity event. Your tax implications depend on when and how you exercise your stock options and how long you hold your vested stocks. Furthermore, many employees will struggle with the high concentration of your net worth in a single company.  Burdened with many questions and a few answers, tech workers often delay early stock option exercise until closer to an IPO or other liquidity event.

So, what do you do next? Here are some ideas that can help you navigate the complex world of equity compensation and early stock option exercise.

1. Know what you own

The best way to master your equity ownership is to take a step back and figure what you own. Reach out to your payroll department or stock option vendor and ask for more information about your stock option holdings.

In general, there are two types of employee stock options – Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). You will most likely own one or the other or some combination of the two. While they may look very similar on the surface, there are significant financial and tax differences between ISOs and NSOs.

ISOs, generally, offer a more favorable tax treatment. There are no taxes due upon your ISO’s exercise, but that can force you to pay an Alternative Minimum Tax.

In comparison, NSOs offer slightly little more flexibility but trigger an immediate taxable income at exercise. Both employers and other stakeholders can receive NSOs.

2. Keep track of key dates and figures

Keeping track of important dates and figures is the next step in mastering your stock options. In most cases, you must start from the moment you receive your job offer. In my article “Guide to understanding your job offer with stock options,” I discuss evaluating a job offer that includes a combination of salary and stock options. There are a handful of important dates and figures that you need to keep track of. Here is the alphabet of terms you have to remember – a number of shares, vesting dates, exercise dates, strike price, fair market value, and vested versus unvested shares.

Furthermore, as you continue working for the same firm, you may receive other stock option grants with different strike prices.  Create a spreadsheet or use the information provided by your option vendor to track all the numbers. It could be cumbersome, but it can help immensely when making early stock options exercise decisions.

3. 83b election

Some companies may allow you for IRC § 83(b) election.  This IRS rule permits companies to offer an early exercise of stock options. When making this election, you will pay income taxes on the fair value of your stock options. The early election is incredibly lucrative for founders and employers of early-stage startups with low fair market value.

The 83(b) election is rarely done due to the complexities in calculating the value of an early-stage startup’s options. If you can determine the value at the time of the grant and decide to pursue this road, you will owe taxes on your options’ fair market value at the grant date. But no income tax will be due at the time of vesting. Another disadvantage of this strategy is the risk of the employee stock price falling below the grant date level. In this scenario, it would have been advantageous to wait until the vesting period.

4. Navigate your taxes

Managing and planning your taxes is by far the most challenging step in the process of early stock option exercise. The biggest hurdle comes from the uncertainty about having enough cash to cover your tax expense. Further on, frequent changes in the company’s fair market value and inability to sell vested shares complicate the process of planning your taxes.

Given so many moving parts, you are probably wondering what your best course of action is. For one, once you reach this junction, it is time to ditch Turbo Tax (no offense, I used it for many years in the past) and seek expert advice. Despite all uncertainty about the future, we advise our clients to start making regular tax projections. Taking a snapshot of your current circumstances will allow you to take an objective view of your finances and make informed financial decisions.

5. Plan ahead for Early Stock Option Exercise

In my practice, I often speak with folks whose company is going public in a matter of days or weeks. A good number of them are considering exercising their stock options for the first time.

There is a strong appeal to do nothing until you approach a significant liquidity event. Waiting to exercise until the IPO eliminates a lot of financial and business uncertainty. However, the waiting strategy has a notable trade-off – paying higher taxes in the future and exposing yourself to material concentration risk.

The advice we give to all our clients is to plan ahead. Do not leave these critical financial decisions for the last minute. Even with the broad range of future outcomes, you could minimize your taxes and reduce your anxiety levels by taking small, measured steps.

What makes the Early Stock Option Exercise decisions so tricky is that no magic formula or one-size-fits-all solution works for everyone. While working with numerous clients, I realize that we all face different circumstances and challenges. If one approach works wells for your colleagues, it may not work very well for you. When we work with our clients, we try to strike the right balance between managing uncertainty and planning for the future.

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Guide to understanding your job offer with stock options

Job Offer with stock options

Guide to understanding your job offer with stock options. Congratulations! You just landed your dream job. However, you might have one big puzzle to solve. Your compensation package includes a combination of a base salary and stock options. The news is exciting but also a bit confusing. What does owning stock options mean for your finances and career prospects?

The rules of stock options can be quite complex. Early decisions can substantially impact your future earnings and tax burden.

In this article, I try to break down some of the key points you need to understand before accepting the job offer with stock options.

What are Employee Stock Options?

Employee Stock Options are a type of equity compensation. Many employers and startups, especially in the tech and biotech space, use stock options to reward and retain talented employees in a competitive hiring environment.

The options give you the right to buy company shares at a specific exercise price during your employment period. By exercising your stock options, you will become a shareholder of your company and participate in future success.

Being a shareholder of a successful company can guarantee your future financial prosperity. However, owning stock options and company share will require a great degree of tax and financial planning.

What type of stock options – NSO or ISO?

There are two main types of employee stock options – Incentive Stock Options and Non-Qualified Stock Options. I have written two articles explaining each type.

  • For Incentive Stock Options, click here.
  • For Non-Qualified Stock Options, click here.

Comparing the two types, ISOs generally have a better preferential tax treatment over NSOs. The exercise of ISOs does not create a taxable income, but you may owe an Alternative Minimum Tax based on your overall annual income. The IRS allows you to treat your total realized gain as long-term capital gains as long as you hold your shares for 2 years after the grant date and 1 year after exercise.

For comparison, the NSO  exercise will automatically trigger a taxable event. You will immediately owe income taxes on the difference between the fair market value and exercise price.

Another significant difference between the two types is that ISO can only be rewarded to employees. In contrast, companies can grant NSOs to both employees, vendors, and other third parties.

What is your share of the equity?

Your job offer will include a specific number of shares you could own once you exercise your stock options.  As high as that number may look, it is a lot more important to know your percentage stake. You need to ask your future employer what is the company’s total number of outstanding shares. The number of your shares divided by the total number of the company’s shares will give your stake at the company. Also, keep in mind that your employer may issue new shares to external investors and VCs in the future, which can be dilutive to your ownership stake.

This information is critical, especially if you are joining an early-stage startup where the number of shares can be very fluid initially.

Vesting Schedule

Receiving the option grant does not immediately make you a shareholder. You can only exercise your stock options once they are vested.  The vesting represents the transfer of ownership from your company to you. Your employer will give you a vesting schedule with a series of dates. On each date or employment anniversary, you will receive ownership of a specific lot or percentage of stock options.

Keep in mind that you must exercise your stock options to own the company shares. Non exercised option can potentially expire, and you will lose your ability to become a shareholder.

Strike price

Strike price or exercise price is the value at which you can buy the company shares once you exercise your stock options. You will be responsible for purchasing the shares. Fortunately, most startups set up the strike price near the $1 range. And most likely, the total cost will be deducted directly from your paycheck. The strike price is important because it will set the stage for your tax dues, depending on the type of stock option you own.

Fair Market Value

The Fair Market Value (FMV) is the price at which your company shares are valued at any given point in time. Your employer should provide you with a fair market value at the time of the stock option exercise.

The FMV of a publicly-traded company is straightforward. It’s typically the end of day market price on the stock exchange.

However, getting the FMV of a private company can be tricky. You will not have a publicly available price. For that reason, startups will hire a third-party expert to calculate the FMV based on recent rounds of funding, comparable company analysis, discounted cash flows, and expected revenue growth projections.

Early exercise

When evaluating your job offer, you can ask if your employer will allow for your stock options’ early exercise. Under IRC § 83(b) election, you can exercise your stock grants early and recognize them as compensation. This election can potentially save you taxes in the long run. The early exercise is especially advantageous for employees and founders of early-stage startups. By choosing early exercise, you pay income taxes at the low fair market value now. No income tax will be due at the time of vesting.  When you sell your shares, you will owe capital gain taxes on the difference between the sale price and the early exercise price.

Liquidity and exit strategy

If your future employer is a public corporation, you can easily sell your shares upon exercise. Selling shares can help you pay taxes on your earnings and diversify your investments.

The liquidity challenge occurs when you are working for a private company. There will be no public market for the stock. You must plan for holding your shares for a long period. Furthermore, exercising stock options can trigger certain taxable, which you will have to cover from your personal savings.

Vesting if the company is acquired.

Often startups are getting acquired before going public. Before you accept the job offer, you may want to know what will happen with your outstanding shares and stock options if your company gets acquired. In the most likely outcome, the acquiring company will cash in all your shares and options. It’s also possible that the acquiring company will exchange your employee shares and stock options for their own.

Termination

What happens with my stock options if I decide to leave the company? Usually, you will have 90 days from your departure to exercise your vested stock options.  Unfortunately, you will lose any nonvested stock options. It will be up to you to keep or sell any outstanding shares of the company.

Taxes

Finally, let’s talk about taxes. You will be responsible for all taxes resulting from the exercising of your stock options and selling your shares. Depending on the exact option type, you can owe ordinary income tax, short term, long-term capital gain tax, or Alternative Minimum Tax.

In some cases, when exercising NSOs, your employer will automatically sell shares to cover all federal and state income taxes. In other cases, especially with private companies, you will have to pay taxes directly from your bank account.

Stock options taxes can be complex. You may face multiple scenarios depending on your company’s success. I strongly encourage you to be proactive and work with an experienced CPA or financial advisor who can objectively guide you through the tax planning process.

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Essential Guide to Your Employee Stock Purchase Plan (ESPP)

Employee Stock Purchase Plan (ESPP)

What is Employee Stock Purchase Plan (ESPP)?

Employee Stock Purchase Plan (ESPP) is a popular tool for companies to allow their employees to participate in the company’s growth and success by becoming shareholders. ESPP gives you the option to buy shares of your employer at a discount price. Most companies set a discount between 10% and 15%. Unlike RSUs and restricted stocks, the shares you purchase through an ESPP are not subject to any vesting schedule restrictions. That means you own the shares immediately after purchase. There are two types of ESPP – qualified and non-qualified. Qualified ESPP generally meets the requirements under Section 423 of the Internal Revenue Code and receive a more favorable tax treatment. Since most ESPP are qualified, I will only talk about them in this article.

How ESPP works?

Your company will typically provide you with information about enrollment and offering dates, contribution limits, discounts, and purchasing schedules. There will be specific periods throughout the year when employees can enroll in the plan. During that time, you are required to decide if you want to participate and set a percentage of your salary to be deducted every month to contribute to the stock purchase plan. The IRS allows up to $25,000 limit for Employee Stock Purchase Plan contributions. Make sure you set your percentage, so you don’t cross over this limit.

At this point, you are all set. Your employer will withhold your selected percentage every paycheck. The contributions will accumulate over time and will be used to buy the company stock on the purchase date.

Offering period

Offering periods of most ESPPs range from 6 to 24 months. The longer periods could have multiple six-month purchase periods. Your employer will use your salary contributions that accumulate with time to buy shares from the company stock on your behalf.

ESPP look-back provision

Some Employee Stock Purchase Plans offer a look-back provision that will allow you to purchase the shares at a discount from the lowest of the beginning and ending price of the offering period.

Employee Stock Purchase Plan  Example

Let’s assume that on January 2nd, your company stock traded at $100 per share. The stock price had a nice run and ended the six month period on June 30 at 120. Your ESPP will allow you to buy the stock at 15% of the lowest price, which is $00. You will end up paying $85 for a stock worth $120.

The price discount is what makes the ESPP attractive to employees of high growth companies. By acquiring your company stock at a discount, the ESPP lowers your investment risk, provides you a buffer from future price declines, and sets a more significant upside if the price goes up further.

When to sell ESPP stock?

Some ESPPs allow you to sell your shares immediately after the purchase date, realizing an instant gain of 17.65%. Other plans may impose a holding period restriction during which you cannot sell your shares. Find out more from your HR.

ESPP Tax Rules

Employee Stock Purchase plans have their own unique set of tax rules. All contributions are pretax and subject to federal, state, and local taxes.

Purchasing and keeping ESPP stock will not create a tax event. In other words, you don’t owe any taxes to IRS if you never sell your shares. However, the moment you decide to sell is when things get more complicated.

The discount is as ordinary income

The first thing to remember is that your ESPP price discount is always treated as ordinary income. You will include the value of the discount to your regular annual income and pay taxes according to your tax bracket.

Qualifying disposition

To get a preferential tax treatment on your stock gains, you need to make a qualifying disposition. The rule requires that you sell your shares two years from the offer date and one year from the purchase date. Your gains will be taxed as long-term capital gains. The long-term capital gain tax rate varies between 0%, 15%, and 20% depending on your income. 

Disqualifying disposition

If you sell your shares less than two years from the offer date or less than one year from the purchase date, the sale is a disqualifying disposition. You will pay taxes on short-term capital gains as an ordinary income according to your tax bracket.

ESPP Dividends

Many publicly traded companies pay out dividends to shareholders. If your employer pays dividends, they will automatically be reinvested in the company shares. You will owe ordinary income tax on your ESPP dividends in the year when you receive them. Usually, the plan discount does not apply to shares purchased with reinvested dividends. Additionally, these shares are treated as regular stock, not part of your Employee Stock Purchase Plan.

Investment risk

Being a shareholder in a solid high growth company could offer a significant boost to your personal finances. In some cases, it could make you an overnight millionaire.

However, here is the other side of the story. Owning too much stock of a company in bad financial health could impose a significant risk to your overall investment portfolio and retirement goals. Participating in the ESPP of a company with a constantly dropping or volatile stock price is like catching a falling knife. The discount price could give you some downside protection, but you can continue to lose money if the price continues to go down. The price of General Electric, one of the oldest Dow Jones members, went down more than 65% in one year.

Remember Enron and Lehman

Many of you remember or heard of Enron and Lehman Brothers. If your company seizes to exist for whatever reason, you could not only lose your job, but all your investments in the firm could be wiped out.

You are already earning a salary from your employer. Concentrating your wealth and income from the same source could jeopardize your financial health if your company fails to succeed in its business ventures.

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your company stock and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety.

Conclusion

Participating in your employer’s Employee Stock Purchase Plans is an excellent way to acquire company stock at a discount and get involved in your company’s future.

Owning company stock often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, it can help you achieve your financial goals, whether they are buying a home, taking your kids to college, or early retirement.

Keep in mind that all ESPPs have different rules. Therefore, this article may not address the specific features of your plan.

 

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All you need to know about Restricted Stock Units (RSU)

Restricted Stock Units (RSU)

What is RSU?

All you need to know about Restricted Stock Units (RSU)….Employers, especially many startups, use a variety of compensation options to attract and keep top-performing employees. A common alternative is equity compensation, which allows employees to share in the ownership and the profits of the company. Equity compensation takes different forms such as stock options, restricted stock units, and deferred compensation. If you are fortunate to receive RSU from your employer, you should understand the basics of this corporate perk. Here are some essential tips on how to manage them.

A restricted stock unit is a type of equity compensation by companies to employees in the form of company stock. Employees receive RSUs through a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with their employer for a particular length of time. RSUs give an employee interest in company stock but they have no tangible value until vesting is complete.

Vesting Schedule

Companies issue restricted stock units according to a vesting schedule.
The vesting schedule outlines the rules by which employees receive full ownership of their company stock. The restricted stock units are assigned a fair market value when they vest. Upon vesting, they are considered income, and often a portion of the shares is withheld to pay income taxes. The employees receive the remaining shares and can sell them at their discretion.

As an employee, you should keep track of these essential dates and figures.

Grant Date

The grant date is the date when the company pledges the shares to you. You will able to see them in your corporate account. 

Vesting Date

You only own the shares when the granted RSUs are fully ‘vested’.  On the vesting date your employer will transfer the full ownership of the shares to you. Upon vesting, you will become the owner of the shares.

Fair Market Value

When vesting is complete, the restricted stock units are valued according to the fair market value (FMV)  at that time. Your employer will provide you with the FMV based on public price or private assessment.

Selling your RSU

Once the RSUs are converted to company stock, you become a shareholder in your firm. You will be able to sell all or some of these shares subject to companies’ holding period restrictions. Many firms impose trading windows and limits for employees and senior executives.

How are RSUs taxed?

You do not pay taxes on your restricted stock units when you first receive them.  Typically you will owe ordinary income tax on the fair market value of your shares as soon as they vest. 

The fair market value of your vested RSUs is taxable as personal income in the year of vesting. This is a compensation income and will be subject to federal and local taxes as well as Social Security and Medicare charges.

Typically, companies withhold part of the shares to cover all taxes. They will give employees the remaining shares. At this point, you can decide to keep or sell them at your wish. If your employer doesn’t withhold taxes for your vested shares, you will be responsible for paying these taxes during the tax season.

Capital gain taxes

When you decide to sell your shares, you will pay capital gain taxes on the difference between the current market price and the original purchase price.

You will need to pay short-term capital gain taxes for shares held less than a year from the vesting date.  Short-term capital gains are taxable as ordinary income.

You will owe long-term capital gains taxes for shares that you held longer than one year. Long-term capital gains have a preferential tax treatment with rates between 0%, 15% and 20% depending on your income.

Investment risk

Being a shareholder in your firm could be very exciting. If your company is in great health and growing solidly, this could be an enormous boost to your personal finances.

However, here is the other side of the story. Owning too much of your company stock could impose significant risks to your investment portfolio and retirement goals. You are already earning a salary from your employer. Concentrating your entire wealth and income from the same source could jeopardize your financial health if your employer fails to succeed in its business ventures. Many of you remember the fall of Enron and Lehman Brothers. Many of their employees lost not only their jobs but a significant portion of their retirement savings.  

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your employer and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety.

Key takeways

Receiving RSUs is an excellent way to acquire company stock and become part of your company’s future. While risky owning RSUs often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, they can help you achieve your financial goals, whether they are buying a home, taking your kids to college, or early retirement.

 
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Incentive Stock Options

Incentive Stock Options

What is an Incentive Stock Option?

Incentive stock options (ISOs) are a type of equity compensation used by companies to reward and retain their employees. ISOs have more favorable tax treatment than non-qualified stock options. While similar to NQSOs, they have a few major differences:

  • ISOs are only granted to company employees.
  • They can only be vested for up to $100,000 of underlying stock value each year
  • ISO must expire after ten years
  • They are not transferrable
  • Long-term capital gain tax is due on the difference between the selling price and exercise price under certain conditions. To receive this tax benefit, ISO holder has to keep the stock for one year and one day after the exercise date and at least two years and one day from the grant date.
  • If the sale date does not meet the above requirements, ISO is disqualified as such and treated as NSO. In that case, you will owe ordinary income tax and short / long-term capital gain taxes
  • Options granted to shareholders with 10% or more ownership must be priced at least at 110% of the Fair Market Value and not be vested for five years from the date of the grant.
  • Alternative Minimum Tax is applicable on the difference between market price and exercise price in the year of exercise. You have to report the difference (also known as the bargain element) to IRS. This may have an impact on your final tax at the end of the year, depending on various other deductions.

Key dates

if you own ISOs, you need to keep track of these important dates:

Grant Date – the date when the options were awarded to you
Vesting Date – the date from when the options can be exercised
Exercise Date – the date when the options are actually exercised
Expiration Date – the date after which the options can no longer be exercised

Important price levels

In addition, you also need to keep a record of the following prices:

Exercise price or strike price – the value at which you can buy the options
Market price at exercise date – the stock value on the exercise date
Sell price – stock value when held and sold after the exercise date
Bargain element – the difference between market price and exercise price at the time of exercise

Tax Considerations of Incentive Stock Options

The granting event of ISOs does not trigger taxes. Receivers of incentive stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date, either. The vesting date opens a window for up to 10 years by which you will be allowed to exercise the ISO.

ISO exercise is not a tax event from the IRS perspective if you meet the holding period requirements by selling your stock after one year and a day after exercise and two years and a day after the grant date. Depending on when you sell the stock after the exercise date, six main scenarios can occur:

Scenario 1

You exercise your options and keep them. No tax due; however, you will have to make an adjustment for Alternative Minimum Tax for the amount of your bargain element.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at the exercise price of $10. Your tax rate is 25%. On the exercise date, you exercise the options and decide to keep the shares indefinitely. The market price on that day is $15.

You are not required to report any additional ordinary income.

However, you must adjust your AMT for $5,000.

(15 – 10) x 1,000 = $5,000.

Scenario 2

You exercise your options and sell them in the same year, less than 12 months from the exercise date. This disqualifies your ISO and converts it to NSO. You will have to report ordinary income on your bargain element and short-term capital gain or loss taxes on the difference between the selling price and the market price at the exercise date. You do not need to adjust for AMT if you sell your ISO within the same calendar year.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months in the same calendar when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

No AMT adjustment is due since you sold your shares in the same calendar year.

Scenario 3

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your selling price is less than the market price at exercise. Since you sell less than a year after the exercise, your ISO is disqualified. Because your selling price is lower, IRS allows you to adjust your bargain element to the lower price

Example: Let’s assume that you are granted 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for five months until the next calendar year when the price drops to $12 and then sell all your shares.

Your original bargain element is $5,000

(15 – 10) x 1,000 = $5,000.

Since the price dropped from $15 to $12, you are allowed to adjust down your bargain element to $2,000 and add it as additional ordinary income.

(12 – 10) x 1,000 = $2,000.

Since your tax rate is 25%, you will owe an additional $500 for taxes on $2,000 of extra income.

$2,000 x 25% = $500

Your total due to IRS will be $500.

You will also have to report an adjustment of -$3,000 ([12 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 4

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your sell price is higher than the market price at exercise. Since you sell less than a year after exercise, your ISO is disqualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 11 months in the next year…when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

 

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 5

You exercise your options and sell them after one year from the exercise date, but less than 24 months from the grant date. Since you sell less than two years after the grant date, your ISO is disqualified.

You will owe ordinary income and long-term capital gain taxes. Your total due to IRS will be $1,700

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 18 months in the next year when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 6 

You exercise your options and sell them after one year from the exercise date, and after 24 months from the grant date. Since you meet the requirements for ISO, your sale is qualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months after the exercise date and 24 months after the grant date when the price goes up to $18 and then sell all your shares.

You are allowed to report $8,000 of long term capital gain.

(18 – 10) x 1,000 = $8,000.

You will also owe $1,250 on your $8,000 of long-term capital gains at either 0, 15%, or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

$8,000 x 15% = $1,250

Your total due to IRS will be $1,250.

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

How to minimize the tax impact of Incentive Stock Options?

  1. Meet the holding period requirements for one year after exercise and two years after the grant date. This will give you the most favorable tax treatment.
  2. Watch your tax bracket. Your tax rate increases as your income grow. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
  3. AMT breakeven – you can exercise just the right number of shares to remain below the AMT tax level. Most accounting software will be able to calculate the exact amount.
  4. Use AMT credits when applicable. In the years when you pay AMT, you can rollover the difference between your AMT and regular tax due as a credit for futures years. The caveat is that AMT credit can only be used in the years when you pay regular taxes.
  5. You can donate or give as a gift your low-cost base stocks acquired through the exercise of ESO. You have to follow the holding period requirement to get the most favorable tax treatment.

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Non-Qualified Stock Options

Non-qualified stock options

What are Non-qualified stock options?

Non-qualified Stock Options (NSOS) are a popular type of Employee Stock Options (ESO) and a favorite tool by employers to reward and retain workers. NSOs are a contract between the employee and the employer giving the employee the right but not the obligation to purchase company stocks at a pre-determined price in a set period.

Non-qualified Stock Options are similar to exchange-traded call options (ETO) in the way they allow their owner to benefit from the rise of the company stock. However, there are significant differences. There is no public market for NSOs. They can be extended for up to 10 years, while most exchange-traded options expire within a year or two. Additionally,  the employer sometimes can change the strike price of the NSOS while this is not possible for ETO.

Another popular equity compensation is an Incentive Stock Option. Click here to learn more about ISOs

Who gets Non-qualified stock options?

Non-qualified stock options are usually granted to company employees, but they can also be given to vendors, clients, and the board of directors. They can be exercised at any time between their vesting date and expiration date. They offer more flexibility than Incentive Stock Options but have less favorable tax treatment. The key requirement set by the IRS for NSOs is that the exercise price can never be less than the fair market value of the stock as of the grant date. While that can be pretty straightforward for publicly traded corporations, there are several valuation caveats for privately held companies.

Keep track of these important dates

If you own Non-qualified Stock Options, you have to be very strategic and keep track of all dates associated with the contract. You should get a copy of your option agreement and read it carefully. The devil is in the details.

The dates you need to remember are:

  • Grant Date – the date when the options were awarded to you
  • Vesting Date – the date from when the options can be exercised
  • Exercise Date – the date when the options are actually exercised
  • Expiration Date – the date after which the options can no longer be exercised

In addition, you also need to keep a record of the following prices:

  • Exercise price or strike price – the value at which you can buy the options
  • Market price at exercise date – the stock value on the exercise date
  • Sell price – stock value when held and sold after the exercise date
  • Bargain element – the difference between market price and exercise price at the time of exercise

 

 Taxes for Non-qualified stock options

The granting event of NSO does not trigger taxes. Therefore, receivers of non-qualified stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date either. The vesting date opens a window up to the expiration date by when you will be allowed to exercise the NSO.

NSO exercise is the first tax event from an IRS perspective. Depending on when you sell the stock after exercise three main scenarios can occur:

Scenario 1

You exercise your options and sell them immediately at the market price. You owe taxes on the difference between the market price and exercise price multiplied by the number of shares

Example: Let’s assume that you are granted NSO equal to 1,000 shares at an exercise price of $10. Your tax rate is 25%. On the exercise date, you sell your shares immediately. The market price on that day is $15.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

5,000 x 25% = $1,250

Your total due to IRS will be $1,250

Scenario 2

You exercise your options and sell your company share a few months later (but less than 12 months) at the current price on that day.

First, you owe taxes on the difference between the market price and exercise price multiplied by the number of shares. Second, you also owe short-term capital gain taxes on the difference between the selling price and the market price on the exercise date multiplied by the number of shares.

Example: Let’s assume that you are granted NSO equal to 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $750 dollars on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

Scenario 3

You exercise your options and sell your company shares one year later at the current price on that day.

First, you owe taxes on the difference between the market price and exercise price multiplied by the number of shares $5,000 ((15 – 10) x 1,000) as additional ordinary income. Second, you also owe long-term capital gain taxes on the difference between the sale price and the market price on the exercise date multiplied by the number of shares.

Example: Let’s assume that you are granted NSO equal to 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $450 dollars on your $3,000 of long-term capital gains at either 0, 15% or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

Tax Impact Summary

  • The receiver of non-qualified stock options will pay taxes on the difference between the stock market value and exercise price at the time of NSO exercise. The value has to be reported as an additional ordinary income.
  • If stocks are sold immediately after exercise at the current market value, you only owe taxes on the difference between market and exercise value.
  • In case you decide to keep the stocks you will owe long-term or short-term capital gains taxes depending on your holding period.
  • If the stock goes down after exercise and you choose to sell, you can report a short-term or long-term capital loss. You can use this loss to offset other capital gains. You can also use up to $3,000 of capital losses to offset ordinary income (like salary, commissions, interest). The remainder of the loss in excess of $3,000 can be rolled over in future years.

IRC § 83(b) election

IRC § 83(b) election allows companies to offer an early exercise of stock options. When making this election employees will pay income taxes on the fair value of their stock options. The early election is especially lucrative for founders and employers of early-stage startups with low fair market value.

This election is rarely done due to the difficulty in calculating the value of the options. If you can determine the value at the time of the grant and decide to pursue this road, you will owe taxes on the fair market value of your options at the grant date. But no income tax will be due at the time of vesting. Another disadvantage of this strategy is the risk of the employee stock price falling below the level at the time of the grant. In this scenario, it would have been advantageous to wait until the vesting period.

What can you do to minimize your tax impact?

  1. Prioritize long-term vs. short-term holding period. Selling shares after holding them for more than 12 months will trigger long-term capital gains which have favorable tax rates over short-term capital gain rates.
  2. Exercise your options as close to the exercise price as possible. However, companies often set very low exercise price, and this strategy may not be viable.
  3. Watch your tax bracket. Your tax rate increases as your income grow. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
  4. You can also donate or give as a gift your low-cost base stocks acquired through the exercise of NSO
  5. If the NSO options are transferable, usually restricted to family members, you can consider giving them away as a donation or a gift