How are employee stock options taxed?
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.
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 an owner 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 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.
A solution for reducing this is risk is obtaining 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 get 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.