If a stock is held for longer than 1 calendar year before being sold it becomes eligible for the lower long term capital gains tax rate, rather than income tax.
Long Term Capital Gains Treatment
Venture backed startup companies are big fans of using incentive stock options to attract and retain employees. A company can issue large incentive stock option grants to its employees with no tax impact on the employee on the date of issue provided the strike price is equal to or exceeds the fair market value of the stock on the date of grant.
Last Minute Exercise on Options
Many times, employees wait to exercise their stock options until a sale or IPO of the company is within sight. Then they exercise and sell the stock. Their reasoning is that they don't want to invest their hard earned cash in a stock that may, like many venture investments, become worthless.
High Tax Consequences
While this last minute exercise may seem rational by conserving cash and avoiding loss, in many cases it is not. Why? Because the option holders have failed to consider the taxes they will have to pay and the huge difference between ordinary federal income tax rates (in 2018 a maximum rate of 37%) and federal long term capital gains rates (in 2018 rates generally ranging from 15% to 20%). There can be additional state tax savings depending on where the employee lives. However, be aware that large amounts of capital gains will reinstate Medicare surtaxes and large amounts of long term capital gains can trigger AMT.
An option holder who exercises at the time of a company liquidity event and immediately sells his stock pays up to 37% in federal income tax plus medicare and social taxes on the gain between the strike price and the sales price of the stock. In contrast, had the same option holder exercised a year earlier (to comply with the long term capital gains rule that shares must be held for 1 year from the date of exercise and 2 years from the date of grant), the federal income tax could have been at the lower capital gains rate. Moreover, both short term and long term capital gains are eligible for reduction by absorbing capital losses you may have on other investments that same tax year. Otherwise, there is a limit to the amount of ordinary income tax ($3000 joint filers, $1500 individual filers) that can be reduced each year from a capital loss rollover.
Exercise Early and Reduce AMT
Another benefit to exercising private company incentive stock options early comes from minimizing Alternative Minimum Tax (AMT) arising from an exercise after the fair market value has appreciated significantly higher than the original strike price of the grant. But if not thoughtfully considered as a part of overall strategy, early exercise to avoid the AMT can backfire. For example, during the late 1990's dotcom bubble many employees exercised early in an effort to qualify for long term capital gains only to have the stock value collapse during the one year holding period. These optionees were left with a huge AMT bill with the IRS but with no money to pay it. Had they exercised even earlier, when the spread between the strike price and fair market value was less or nonexistent, they could have spared themselves this issue. Or if they sold the same year as the exercise, they could have gotten an AMT Disqualifying Disposition.
Minimizing the Risks
There can be clear advantages with early exercise of incentive stock options - sometimes the earlier the better - but the risk and cost associated with exercising stock options can be burdensome for many individuals. Where to get the funds? How much risk to take?
The ESO Fund can help alleviate these risks by providing the funds to exercise stock options and to pay applicable taxes such as AMT. No repayment is due unless and until there is a liquidity event involving the company that issued the shares, such as a sale or IPO. See this link for a summary of other methods to save on taxes. For more information regarding how working with ESO can benefit you, please contact us.