Stock Options 101
Your stock options represent the right to purchase shares of your company at a fixed price, known as the exercise price. You earn the right to exercise your options over time through a process called vesting, the timeframe of which is stipulated by a vesting schedule. There are two types—ISOs and NSOs—and early-stage companies will typically issue a mix of both to their employees.
For each tranche of options that you’ve been issued, be aware of three key numbers:
- Your strike price (aka exercise price): how much you pay to purchase each share.
- The 409A value (aka fair market value) of the shares, as of the time you exercise the options. For private companies, the 409A value is an independent appraisal of how much the private company’s stock is worth. After the IPO, this value becomes the company’s public stock price.
- Your sale price: the price at which you later sell the shares.
On a high level, here is the difference between ISOs and NSOs:
- Pay ordinary income tax on (409A value - exercise price) when you exercise your options. So, if you pay $2 to purchase each share and the 409A value is $10, then you’re taxed on the $8 spread.
- Pay capital gains tax on (sale price - 409A at the time of exercise) when you sell the shares. So, if you exercise the shares when the 409A value is $10, then sell those shares for $50, then you’ll be taxed on the $40 capital gain. (Depending whether you held the shares for over a year before selling them, you’ll either pay long-term capital gains or ordinary income tax rates on them.)
- Pay no tax when you exercise—unless you trigger the alternative minimum tax (AMT) (explained below).
- Pay long-term capital gains tax on (sale price - exercise price) when you sell—if the shares are sold at least one year after exercising, and at least two years after your options were granted. Otherwise, (sale price - exercise price) will be taxed as short-term capital gains (roughly ordinary income).
Note: There's something called a disqualifying disposition, which refers to selling, transferring, or exchanging ISO shares before satisfying the ISO holding-period requirements (two years from date of grant and one year from date of exercise). If you sell, transfer, gift, or short the stock too soon, you lose the tax benefits of ISOs.
Alternative Minimum Tax for ISOs
Upon exercising your ISOs, you will likely qualify for the Alternative Minimum Tax (AMT), which is designed to make sure every taxpayer pays at least a minimum percentage of income tax. AMT was designed to prevent “rich” taxpayers from paying $0 of income tax. Congress wrote the law such that AMT and Ordinary Income Tax run in parallel, and we have to pay whichever one is greater.
A common driver of AMT is the ISO bargain element: the (409A value - exercise price).
You will generally owe AMT if:
- Your total bargain value ( [409A value - exercise price] * total ISOs exercised) exceeds the AMT exemption amount (which is $75.9k for single taxpayers and $118.1k for married couples filing jointly in 2022)
- The tax you owe under the AMT calculation exceeds the tax you owe under regular tax calculations.
You will have to pay AMT when you file your tax return for the year that you exercise your ISOs (it is not withheld at the time you exercise), so make sure to plan accordingly.
There is something called the Alternative Minimum Tax (AMT) credit that benefits taxpayers. When you pay your AMT bill, you automatically trigger the AMT credit, which can be used to lower your federal income tax bill when the amount you owe on taxes is more than what it would have been under the AMT in a future year. That's because, unlike a deduction that lowers the total amount of income on which you are taxed, a credit actually lowers your tax bill dollar-for-dollar. AMT credits are intended to offset double taxation in the future.
- In 2021, you exercise ISOs and end with a total tax bill of $20k, all of which was because of the AMT income from ISO exercise. You’ve also generated a $20k minimum tax credit.
- In 2022, the same company has an IPO and your RSUs trigger, driving you into top tax rates on your income (37%). Your minimum tax credit will apply until the credit is either depleted, or your ordinary tax is equal to AMT, whichever occurs first.
- In an alternate scenario, you sell your ISOs in 2022 after holding for one year. Because you have a higher basis in the shares for AMT, you will recognize more gain for regular tax than AMT. In this case, your minimum tax credit will apply against the gain recognized.
When you want to exercise your ISOs and potentially trigger AMT, you can strategically tax plan ahead to reduce your AMT Payable (the difference between your total income tax liability under the AMT rules and tax due under Ordinary Income rules). Consult your Tax Advisor for more guidance.