How are employee stock options taxed?
If you are granted, plan to exercise, or have already exercised stock options, it is important to understand their tax treatment. Employee Stock Options are not taxable when granted (except for RSUs which are taxed differently, but not technically "options"). ESO taxation begins when the options are exercised, and taxes are calculated based on the spread between the current Fair Market Value (FMV) and the exercise price. Taxes are also paid when the resulting shares are sold (whether through an IPO, M&A, or private market secondary sale).
The post will cover how stock option taxation works at two points in time:
1. Upon Exercise
2. When Sold
How are stock options taxed upon exercise?
Your options are taxed differently upon exercise depending on what type of options you own, however the way taxes are calculated and the cost of exercising remains the same:
The Alternative Minimum Tax (AMT) can apply to current and former employees of privately held companies when they exercise their incentive stock options (ISOs) if the fair market value is higher than the exercise price. AMT can have a significant cash impact on those who exercise their ISOs.
Holders of non-qualified stock options (NSOs) are subject to tax at exercise if the fair market value of the stock is higher than the exercise price (“spread”). If you leave a company and negotiate an extension on your exercise period that is longer than 90 days after your final day of employment, your ISOs will become non-qualified stock options. NSO stock options are more typically associated with non-employees such as contractors and outside business partners. Moreover, employers are required to withhold at least 25% of the spread at the time of the exercise. This withholding includes federal, Medicare, FICA, and applicable state income taxes. Since the cost of exercising stock options could already be very high, the addition of taxes makes the entire investment more burdensome as well as risky.
While not technically stock options (see more on RSUs vs Stock Options), RSUs are a common type of employee equity, particularly at late stage private companies. RSUs are either taxed when they vest, or more commonly, taxed at liquidity based on a "double trigger" vesting schedule. The two triggers involved are (1) vesting of the RSU and (2) liquidity. This means the owners of RSUs will only get taxed for RSUs that have been vested once the company goes public, and the RSUs become liquid. Employees with RSUs will incur taxes even if they have no plans to sell.
How is FMV determined?
The FMV is determined by a 409A Valuation which is required by law to be updated every 12 months or any time a company closes a funding round. It is calculated either by the company internally or by an independent firm. The 409A will be valued based on similar publicly traded companies, the company's cash flow, or the company's assets.
What does this all mean?
Let’s say you are granted 10,000 options with an exercise price of $1. If the current FMV is $5 your taxable income will be $5 minus $1 equaling $4 per share. Thus your taxes will be based on $40,000 of income (then adjusted depending on the applicable tax rate). It is easy to see how the exercise of options can charge a hefty price, thus why it often makes sense to exercise your options with The Employee Stock Option Fund to preserve your cash and avoid unnecessary personal risk.
How are stock options taxes when sold?
Employee stock options are also taxed upon sale. While technically you are selling the shares that are issued as a result of the options exercise, knowing how you will be taxed on the back-end is important. If the sale occurs within 1 year of the exercise, the gains will be taxed as short-term capital gains aka income (however, ISOs sold within a year of the exercise will not be subject to AMT). Any sale taking place beyond one year of exercise is subject to the lower long-term capital gains rate.
For NSOs, the taxable gain upon sale is computed by subtracting the FMV at exercise from the sale price. Back to our example from before, let's say you eventually sell your 10,000 shares for $10 per share. Your taxes will be paid on $10 minus $5 equaling $5 per share of income aka $50,000 of taxable gain.
For ISO, despite the favorable tax treatment at exercise, the taxable gain is computed by subtracting the strike price from the sale price. Referencing the example again, selling at $10 per share means your taxes will be paid on $10 minus $1 equaling $9 per share of income aka $90,000 of taxable gain. This may seem like ISOs get double taxed, and in a way they do. However, if you did pay AMT on the exercise, you can recoup that money through a process called AMT Credits. This process isn't completely straightforward so please check out this page for more on how to claim AMT Credits.
A solution for reducing this risk is to obtain an advance from the Employee Stock Option Fund to cover the entire cost of exercising your stock options, including the tax. An indirect benefit of letting ESO finance your NSO option exercise is reducing the AMT on your ISOs in case you prefer to only exercise your less expensive options on your own. Similarly, letting ESO finance your ISOs can give you a disqualifying disposition that can eliminate much, if not all, of the AMT and defer your overall tax liability.
For more information on tax savings, please contact us at the Employee Stock Option Fund.