How are employee stock options taxed?
Employee Stock Options are not taxable when granted (Except for RSUs which are taxed differently). 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.
Your options are taxed differently at exercise depending on what type of options you own, however the way taxes are calculated and the cost of exercising remains the same:
How is the 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 companies cash flows, or the companies assets.
What does this all mean?
Let’s say you are granted 1,000 options with an exercise price of $1. If the current FMV is $2 your taxable income will be $2 - $1 = $1 per share, thus your taxes will be based on $1,000 of income (then adjusted depending on the applicable tax rate). It is easy to see how exercising 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. Employee stock options are also taxed upon sale. If the sale occurs within 1 year of exercise, they are taxed as short-term capital gains (ISOs sold within a year of exercise will not be subject to AMT). Any sale taking place beyond one year of exercise is subject to the lower rate.
For more information on tax savings, please contact us at the Employee Stock Option Fund.