Equity Guide for Employees at Fast-growing Companies

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. Leading up to the IPO, the fair market value of your shares will likely rise greatly towards the company’s preferred price (or at least fluctuate). These fluctuations may greatly impact your tax calculations, and your company's finance team should keep you up-to-date on them.
• Your sale price: the price at which you later sell the shares.

On a high level, here is the difference between ISOs and NSOs:

For 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 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 on them. 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.

For ISOs

• Pay no tax when you exercise—unless you trigger the AMT (details 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).

Upon exercising your ISOs, you will likely qualify for the Alternative Minimum Tax, or AMT. Back in 1969, 155 individuals with incomes over $200,000 managed to pay zero federal income taxes, triggering popular outrage. The AMT was introduced to prevent this from happening again.

The AMT is calculated based on the bargain element: the (409A value - exercise price). You owe AMT if:

1. Your total bargain value ( [409A value - exercise price] * total ISOs exercised ) exceeds the AMT exemption amount. For the 2023 tax year, the AMT exemption is $81,300 for individuals and $126,500 for married couples filing jointly. For the 2024 tax year, it's $85,700 for individuals and $133,300 for married couples filing jointly. The AMT is indexed yearly for inflation.
2. The tax you owe under the AMT calculation We won’t discuss how to calculate your exact AMT burden in this article, but it will come out to 26-28% of your total bargain value. 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.

Upon exercising your ISOs, you pay AMT. Then, when you sell those shares, you’re taxed again on your capital gains. To lessen the blow of thus being taxed twice on ISOs, Congress introduced AMT credits.

Suppose you paid $5000 in AMT in 2019. In any subsequent year where you don't owe AMT (say, 2020), you might be able to get back some or all of that $5000. There are a few conditions for getting this tax credit:

1. You can't owe AMT in 2020.
2. The maximum amount of AMT credit you can claim for 2020 is [regular tax bill for 2020 - AMT amount for 2020]. After you claim your credits for 2020, any of the original $5000 that's left over can be used toward a subsequent year's tax deduction.

There are many other caveats that may warrant speaking with a financial advisor. But the bottom line is: you may want to try to strategically maximize the amount of AMT credit that you can claim later. Or, you can limit the number of ISOs that you exercise and stay below the AMT exemption amount (thus avoiding the AMT altogether).

RSUs turn into shares of your company’s stock when they vest. They’re typically issued by companies valued at over $1 billion.

RSUs are subject to either single- or double-trigger vesting. Single-trigger RSUs can vest before IPO. This means you’ll owe taxes on them as they vest (because you’re coming into ownership of new shares of stock). However, if the company is still private, you won’t be able to sell those shares to make money to pay the taxes you owe on them.

That’s why many companies instead offer double-trigger RSUs, which only vest after the IPO. That way, you’ll only owe taxes once the company is public and you can actually sell those shares. So, for the year that your company IPOs, be prepared to pay taxes on any double-trigger RSUs that you vest. Your RSUs may vest either on IPO day or after the lockup period, depending on the company.

When your RSUs vest (whether before or after IPO), you’ll owe ordinary income tax on the 409A value of your newly issued shares as of that day. As a reminder, the 409A value after IPO is equivalent to the company’s public stock price. Then, when you sell those shares, your profit (i.e. [sale price - 409A value as of the day the shares vested]) will be taxed as capital gains. Again, these qualify for long-term capital gains tax treatment if you hold onto the shares for over a year.

You can actually exempt your stock from all the federal taxes we’ve discussed above, if it counts as qualified small business stock (QSBS). Your stock might qualify as QSBS if:

• At the time that your stock was issued (i.e. when you exercised your options), your company’s gross assets did not exceed $50 million.
• You’ve held the stock for at least five years before selling it.

There are a number of other caveats. But, if you can get QSBS treatment, you’ll almost certainly save a lot of money in taxes.