Joining a startup is an exciting endeavor. It’s fun, hectic, frustrating and provides an opportunity to learn and gain skills that aren’t as easy to come by in a more corporate environment. The lure of a startup often comes in the form of company stock options, which offer the potential to provide the recipient with a windfall if everything works out. Stock options or equity compensation can often be the primary form of compensation, especially in early stage companies where cash is hard to come by. Your strategy around exercising and selling your stock options impacts every area of your financial plan. Understanding the basics around stock options and their tax treatment can help you put together a plan that is unique to your current situation and future goals.
Grant Date: Date on which option is granted
Vesting Schedule: The schedule that dictates when you may exercise your stock options
Vest Date: The date on which you may exercise your stock options
Exercise Price/Strike Price: The price that is paid to exercise a stock option and acquire shares of the underlying stock
Sale Price: The price the shares of stock are sold for
Spread: The difference between the exercise price and the price of the underlying stock on the day the options are exercised
409A Value: An appraisal of a private company stock to determine its fair market value. Typically good for 12 months unless there is a material event
Supplemental Income: Compensation that is received in addition to regular income. Supplemental income is also subject to Social Security, Medicare, and FUTA taxes
- Offer Letter
- Grant Document
- Employer Stock Plan
Employee Stock Option Basics
Your employee stock options give you the right to purchase your company’s stock at a fixed price, which is the exercise price. Companies will implement a vesting schedule, which will provide the timeframe over which you earn the right to exercise your options. Your vesting schedule can typically be found in your offer letter or the grant form.
There are two types of employee options; Incentive Stock Options/Statutory Options (ISOs) and Non Statutory options. Startups frequently offer a mix of both to employees.
The options you receive are typically given through different grants, which are specified in your grant documents and have different identification numbers within the equity compensation account set up by your employer. It is important to track the different grants you receive. A few figures to pay attention to include:
- The Exercise Price/Strike Price
- The 409A Value
- Sale Price
There are a few differences between ISOs and NSOs that affect the way they are taxed and their impact on your overall financial plan and picture.
Employee Stock Option Basics – Tax Treatment
Inventive Stock Options (ISOs):
ISOs are only available to employees of the company and receive favorable tax treatment if the statutory holding requirement is met. A high level overview of the tax treatment of ISOs:
- There is no tax due upon the exercise of ISOs (unless there are AMT implications).
- No payroll taxes of any kind is required upon the exercise of ISOs.
- You pay Long Term Capital Gains taxes when the shares are sold if you met the holding period requirements.
- The holding period requirement is at least one year from the date the options were exercised and two years from the date the options were granted. This is referred to as a qualifying disposition.
- Capital Gains tax is the applied to difference between the exercise price on the options and the price it was sold for. So if you exercised for $3 and sold for $27, the capital gains tax would apply to the $24 difference.
- If the holding period isn’t met the sale is considered to be a disqualifying disposition. In this instance the spread will be taxed as ordinary income .
Non-statutory Options (NSOs):
NSOs aren’t eligible for the favorable tax treatment possible with ISOs, and can be granted to employees, advisors, independent contractors, etc.
- When you exercise NSOs you pay ordinary income tax on the spread (409A – exercise price).
- Payroll taxes apply upon the exercise of NSOs.
- You pay capital gains tax rates on any gains above the spread.
- If held for one year or less you will pay Short Term Capital Gains which is taxed at ordinary income rates
- If held for one year and one day or more you are taxed at Long Term Capital Gains Rates
- Long Term Capital Gains rates are tiered at 0%, 15% and 20% depending on your adjusted gross income for the year
Alternative Minimum Tax (AMT) and ISOs
The Alternative Minimum Tax is a tax that runs parallel to the normal tax system. Although there is no tax due when you exercise your ISOs, the bargain element on the date of exercise is considered an “add back” item under the AMT code, and increases your Alternative Minimum Taxable Income (AMTI)*. You owe AMT if the bargain element value exceeds the AMT threshold amount. The threshold amounts for 2022 are:
- $75,900 for Single Taxpayers
- $118,100 for Married Couples Filing Jointly
You also owe AMT Tax if the AMT tax you have to pay is higher than the tax you owe under the regular tax code. AMT tax rates are either 26% or 28% depending on your income for the year, and will have to be paid if the ISOs you exercised are held through a calendar year. AMT tax is not withheld by your employer and should be taken into account when formalizing your cash flow and expenses for the year.
*The exact AMT calculation is robust and is not covered in this article. It is best to approach a tax professional when determining your exposure to AMT
Having an understanding of how stock options work can help you evaluate job offers and determine a systematic approach to exercising and selling your options.
Disclaimer: The information on this site is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This information should not be relied upon as the sole factor in an investment making decision. This content is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, Hereford Financial disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose.