Taxes and Options
Option exercise comes with some unfamiliar tax implications. Learn techniques to keep more your hard-earned gains.
Options taxes can be complex. This guide will help you make sense of them.
Try to plan ahead. You don't want to get surprised by taxes. If you understand when you'll be taxed, you're already halfway there.
Options taxes are triggered at exercise and again when you sell the shares. How much you'll be taxed - if at all - is dependent on the type of option, where you live, and how long you've owned the shares.
The taxes at exercise are calculated based on the value of the bargain element - the difference between the Strike Price and the market price per share at the time of exercise. The taxes when you sell the shares are calculated based on the value of the shares at the time of sale.
Taxes Due at Grant and Vesting
None! This is why options are so popular for startups.
Taxes Due at Exercise
Taxes due at exercise depend on whether the options are ISOs or NSOs. You can owe taxes at the federal, state, and local levels.
What to Keep In Mind
Federal Taxes
Federal taxes apply to everyone. If your options are NSOs, you're stuck paying ordinary income tax on the full bargain element. If the options are ISOs, the IRS gives you a freebie - the first $100K of that bargain element is income tax-free every year.
Once you cross that $100K threshold, any remaining options are automatically taxed as NSOs - you owe ordinary income tax on the bargain element.
The threshold is based on the value of the options when they were granted, not when they vest or are exercised. The math here can get a little tricky and can be easier to understand by way of example. Feel free to scroll down to example scenarios at the bottom.
Even though you get an income tax freebie with ISOs, you may still owe additional federal taxes under the Alternative Minimum Tax. The alternative minimum tax (AMT) is a federal tax that ensures you pay your "fair share" in taxes. The AMT uses a different calculation method to determine what you may owe. The $100K income tax freebie will still be counted towards the AMT and you may owe additional taxes.
The IRS put together a guide to the AMT including instructions to determine if it's applicable to your situation.
State & Local Taxes
Almost all states and localities follow the federal tax code on ISOs and NSOs. Unless otherwise specified below, you get a $100K state-and-local income tax freebie on ISOs and owe state-and-local income taxes on the bargain element for NSOs.
Pennsylvania is the only state that does not follow federal tax treatment for ISOs. If you reside in Pennsylvania, you'll owe state income taxes on the entire bargain element regardless of whether the options are ISOs or NSOs.
Five states have a state alternative minimum tax: California, Colorado, Connecticut, Iowa, and Minnesota. If you live in one of those states, you'll need to calculate your state income tax liability under two different systems - regular and AMT - and pay the higher amount.
SmartAsset has a helpful income tax calculator that incorporates federal, state, and local taxes. At the bottom of the page, you can find state-specific tax resources.
Cashless Exercise
A cashless exercise is when the company allows you to sell some of your options and use the proceeds to exercise other options, all in one transaction. It can trigger income tax liabilities the same as if you paid to exercise the options.
Think of a cashless exercise as a multiple-step operation. First, you sell some of the options and get paid in cash. Then you use the cash to exercise other options. Both steps - the sale and the exercise - trigger ordinary income tax liabilities just like the ISO and NSO exercises outlined above.
Taxes Due at Sale
Taxes due when you sell the shares are calculated on the difference between the share price when you exercised the option and the share price when you sell the shares. The tax rate depends on how long you've owned the shares and where you live.
For the avoidance of doubt: your option strike price is not relevant to calculating taxes due at the sale of shares.
Federal Taxes
If you've owned the shares for longer than a year, you'll owe long-term capital gains tax. The current long-term capital gains tax rate is between 0 and 20% depending on your income and filing status.
If you’ve owned the shares for less than a year, the sale will be taxed as ordinary income. The ordinary income rate is typically higher than the long-term capital gains rate.
It doesn't matter how long you owned the options. The clock on ownership starts when you exercise the options.
State & Local Taxes
Most states will tax sales of shares as ordinary income with no preferential long-term capital gains tax rate.
Nine states have preferential tax treatment for long-term capital gains.
Most localities (e.g. cities) tax sales of shares as ordinary income. We're not aware of any locality that has a preferential long-term capital gains tax rate.
83(b) Election
If you are able to early exercise, you may be able to take advantage of an 83(b) election.
An 83(b) election is a letter you send to the IRS electing to be taxed on your equity on the date it was granted to you rather than when it vests. You can only file an 83(b) on equity, not on options. For the purchases of tax calculations only, an early exercise allows you to "own" the equity in the eyes of the IRS.
The form must be filed within 30 days of the grant. No exceptions.
Cooley LLP has a helpful primer on the 83(b) including instructions on how to file.
Comparing Scenarios
The taxes you may owe can vary enormously depending on when you exercise. Below, we’ll look at the three outcomes for an employee depending on how long they wait to exercise their options.
Our employee's details:
- Receives 25,000 ISOs at signing that vest monthly with a one-year cliff
- Exercise price and fair market value at grant are both $10 per share
- Salary is $150,000 a year
- Tax status is Single-filer
- Lives in New York City
- Start Date: April 1st, 2022
Scenario #1: Exercise At The End of Year 4
The employee has been with the startup for four years. The fair market value of the company has increased to $50 per share. The bargain element is now $1M. The employee exercises all 25,000 options at the end of year four.
Even though all of the 25K options were granted as ISOs in April 2022, not all will qualify. An ISO/NSO split is needed in year 2.
The employee needs $250,000 in cash to exercise the options. They will also need to cover the increased tax bill of $347,845.
So of the original $1.15M compensation, the employee takes home $802,155 after taxes in a combination of cash and shares.
Scenario #2: Exercise At The End of Year 7
The company has done even better. The fair market value of the company has increased to $200 per share. The bargain element is now $4.75M. The employee exercises all 25,000 options at the end of year seven.
The ISO/NSO split hasn't changed because it's based on the fair market value of the shares at the time of grant. The cash needed to exercise the options is similarly unchanged because it's based on the exercise price. It's still $250,000.
It's the taxes that have increased by a lot. As the bargain element gets bigger, so too do the taxes owed. The employee will need $1,416,153 for taxes.
So of the original $4.9M compensation, the employee takes home $3,483,848 after taxes in a combination of cash and shares.
Scenario #3: Cashless Exercise at IPO At The End of Year 9
The company is going public at $300 per share. The bargain element is now $7.25M. The employee does a cashless exercise of all 25,000 options after the lockup period ends following the IPO.
The ISO/NSO split is the same as before. The cash required to exercise and income taxes are different.
The cost to exercise is still $250,000, but the employee chooses to do a cashless exercise. In a single transaction, they "sell" 834 options back to the company - worth $241,860 - to "pay" to exercise the remaining 24,166 options. No cash is actually exchanged between the employee and the company.
The employee now owes taxes on the entire transaction no different than if they had spent $250,000 in cash to exercise all of the options. The employee will need $2,128,418 for taxes.
So of the original $7.4M compensation, the employee takes home $5,271,583 after taxes in a combination of cash and shares.
Scenario Comparison
The employee paid more in taxes and ultimately owned less of the equity the longer they waited to exercise. It was almost a $2M difference in total take home compensation across the nine years.
