If you work at a company that offers employee stock options or employee stock, you might be wondering how these Employee Stock Options are taxed. You are not alone! Many startup employees have stock options as part of their jobs.
I went through the same landscape a few years ago, and let me tell you: There are many different and confusing rules in the tax code that are not making it easier! On my journey, I’ve found many conflicting posts about how they work and what to look out for. In my case, I was dealing with ISO shares. Now that I have gone through the whole process from start to finish, I’d like to share my personal experience.
In this post, I will share some unique knowledge about employee stock options and highlight the main differences. We will touch on Alternative Minimum Taxes as well as RSU Stocks. If you are thinking about exercising your employee stock options, read on and learn about the many pitfalls that you are expected to navigate.
The Different Employee Stock Options and Stocks
Private and public companies can offer various types of Stock Options or Stock as additional compensation and benefit. Since there are many pitfalls to navigate when dealing with these stocks and options, you need to know the implications of vesting and exercising them. Every type of stock option has unique tax consequences and tax implications you need to be aware of, as exercising and buying stocks can create a large tax bill for you.
Navigating capital gains taxes in a smart way can lead to significant savings. Read my guide “How To Avoid Paying Capital Gains Taxes On Stocks” for more tips on this topic.
What Does Vesting Mean?
Your granted employee stock options often come with a vesting plan. By definition, stock options give you the option to exercise stock. You will basically need to pay for the stocks. Usually, the strike price (aka the price you pay for one stock) is part of your stock option agreement – an agreement you signed when you got hired or when you got a new stock option grant. Also, part of that plan is your vesting schedule. This schedule regulates when you can purchase or exercise the granted stock options.
Imagine you got a stock option grant of 10,000 stocks. As part of that plan comes a 4-year vesting schedule. 25% of the stocks get vested after one year. After that, the rest of the stocks get vested each month for the remaining 36 months. This will be 7,500 / 36 = ~208 stocks per month. You will likely have a similar 4-year plan, but other variations exist. The one-year cliff of 25% is also very common, so companies don’t incentivize you to get hired, exercise and leave again.
Here is a basic comparison of ISO vs. NSO stock options:
|Incentive Stock Options||Non-Qualified Stock Options|
|$100k limit / year||no limit per year|
|No tax at exercise (but maybe subject to AMT)||Ordinary Income Tax at exercise|
|qualifying disposition possible (1 year holding + 2 year granted)||long-term capital gains possible (1 year holding)|
ISO Stock Options
If the type of employee stock options you get is an Incentive Stock Option, they may get a preferred tax treatment. They are also sometimes referred to as Statutory Stock Options.
But what is that favorable tax treatment? Your tax benefit is that you don’t have to pay ordinary income tax at the time you exercise. But you might not be fully off the hook if the amount of stock you exercise is large.
If your spread between your strike price and the exercise price is large, you may owe an Alternative Minimum Tax. But I will cover more details on that topic later in the post since there are many rules and exceptions to keep in mind.
If you held your stock for at least one year from the exercise date and two years from the grant date, you will pay long-term capital gains taxes on your gains. You call it a qualifying disposition if your stock fulfills these requirements. If not, it is called a disqualifying disposition. These holding period requirements allow you to save much money since long-term capital gain rates are much lower.
Understanding The $100,000 Limit
The ISO $100K limit exists, so you don’t take too much advantage of tax benefits. The rule states that the maximum amount of ISO stocks you can receive in one year is $100,000.
The calculation is simple: Take your entire grant and divide it by the number of years it takes to fully vest it. You now have the number of shares that become exercisable per year. Next, you multiply that by the strike price. If your result does not exceed $100,000, your options are not subject to the rule. If it is higher, any grant that is above the limit will be treated as NSO.
One strategy you can follow if you are above the limit is to only exercise up to the limit in one year, regardless of how many ISO stocks you can exercise. Then you repeat it every year.
Depending on the state you live in, you might also have to pay additional state taxes.
NSO Stock Options
With Nonqualified Stock Options as your employee stock options, you will have to pay taxes on your capital gains at the time you exercise the stocks. The part you pay taxes on is the spread between your strike price and the fair market value (FMV) of the stock at the time of the exercise.
When your strike price is $1.45 and the FMV is $5.96, you will pay taxes on $5.96 – $1.45 = $4.51 per stock. That difference is also called the bargain element. If you exercise 10,000 stocks, you will pay taxes on a capital gain of $45,100.
When selling Nonqualified Stock Options for a profit, you must also pay taxes. But you only pay taxes on the new capital gain. If you hold your stock for at least one year, you pay the lower tax rate for long-term capital gains. Otherwise, you will again pay ordinary income tax on your gain.
In the above example, imagine selling 10,000 stocks after one year for $7.32 per stock. Now you will pay taxes for $7.32 – $5.96 = $1.36 per stock. Your total capital gain from the sale is $13,600.
Remember that you might also have to pay additional state taxes depending on the state you live in.
For more detailed information on Non-Qualified Stock Options, check out my detailed guide “Explained: How Do Non-Qualified Stock Options Work.”
Restricted Stock Units are another form of compensation that companies can offer. They are not stock options but stock grants. This means that you will get the stock without paying for it with your own money. RSUs are taxed when they vest and are a taxable event for you. Sometimes, your employer will withhold some of the RSUs to cover your taxes. In other instances, he might give you the option to pay the taxes with cash if you want. This option allows you to hold onto more stocks.
The tax rate you pay for RSUs is the ordinary income tax rate. Income from your RSUs is also subject to social security and medicare tax withholding. You might also have to pay additional state taxes depending on the state you live in.
Should You Exercise Your Employee Stock Options?
Unfortunately, there is no clear yes or no answer to this question. It depends on your personal situation.
You should talk to a financial advisor and tax professional about your specific situation, your stock options, and the best strategy to pursue. Finding a good financial advisor is not easy. I recommend the Garrett Planning Network, the National Association of Personal Financial Advisors (NAPFA), and the XY Planning Network. These networks can get you in contact with a fee-only advisor. No matter how much money we are talking about, it will not change your costs.
Examples Of Exercising Early vs. Exercising Late
To give you an idea of what exercising early vs. exercising later can mean, take a look at these 2 examples for NSO stocks:
Erika works at a private tech startup, and things are going very well. The startup got a first financing round, and as part of her job offer, she got an employee stock options agreement for 100,000 stocks at a strike price of $0.23. Erika really believes in the company and exercises all her stock options the moment they are vested. In total, she invested $23,000 over 4 years. Since the company is still private after 4 years and no additional capital was raised, the strike price remained unchanged at $0.23. This means that she didn’t have to pay any taxes as there was no capital gain yet.
The company eventually went IPO 5 years later and became a public company now valued at $43.51 per stock in the open market. Erika still owns all her stocks, and they are now worth $4,351,000. When she sells any stocks, she will have to pay long-term capital gains taxes on the spread between $0.23 and the price of one stock at that time.
Paul started around the same time as Erika, and he also got the same employee stock options agreement. He didn’t exercise any stocks until right before the IPO of the company, because he didn’t want to lose his money. The company was valued at $65 per stock before the IPO, and he now felt comfortable exercising his NSO stocks. His spread is now $65 – $0.23 = $64.77, so he will have to pay short-term capital gains taxes on a capital gain or taxable income of $6,477,000. Since he does not have enough money, he must immediately sell enough stocks to cover the taxes he now owes.
Both scenarios are very common examples you will find. It is sometimes hard to wrap your head around the large numbers that can come with stock options. Although Erika’s scenario seems more favorable, she did take a huge initial risk. She could not have known beforehand if and when the company would IPO. In the worst case, the company may never be public, and she would have a complete capital loss.
What Is Alternative Minimum Tax For Employee Stock Options
First, the Alternative Minimum Tax (AMT) is only important for your ISO stock options. When you exercise ISO stocks, you might have to pay AMT, depending on your situation.
Think about it like this: You normally pay income tax on your ordinary income.
Calculate the AMT your exercise will produce before you exercise ISO shares. If the AMT exceeds your total income tax, that difference is the AMT that you will have to pay for the tax year. Otherwise, the income tax is what you will have to pay.
There is a great calculator available at esofund.com. If we use that to calculate the AMT that Paul from above would pay if his stock were ISO stock, he would be looking at something like this:
|Regular Income Tax Breakdown|
|Regular Federal Income Tax||$26,996.48|
|Total ISO Spread||$6,477,000.00|
|AMTI (AMT Income)||$6,597,000.00|
|AMTI – Exemption (Min $0)||$6,597,000.00|
|Alternative Minimum Tax (Rate: 35%)||$2,308,950.00|
Since the calculated AMT is well above his regular federal income tax, he will owe the difference between the calculated AMT and the already-paid taxes. The cost for his original exercise is minuscule in comparison:
Additionally, paying AMT will give you access to AMT Credits. You can use these credits to lower your income taxes in the following years when you don’t pay AMT because you don’t exercise and stock. There are certain limitations on how many credits you can use based on your total income and your calculated AMT in the year.
Due to the mentioned limitations, it will usually take you many years to fully utilize all your AMT credits.
Final Thoughts – How Are Employee Stock Options Taxed: ISO vs. NSO
If you are one of the lucky individuals who has access to employee stock options, you will need very specific knowledge to fully understand the consequences of exercising them. The rules and regulations on how they are treated are complex. There is also a lot of conflicting information out there about this topic.
In this blog post, we looked at the main differences and similarities between ISO and NSO stocks. We also touched on RSUs as an alternative form of compensation. ISO stocks come with an additional layer of complexity with the Alternative Minimum Tax rules. I hope that this blog post helped you understand the rules better.
The examples I’ve shown highlight that the time of exercise can profoundly impact your tax situation.
Remember that you don’t have to tackle the journey alone. You can talk to a financial advisor and tax professional about your situation, stock options, and the best strategy. I recommend a fee-only advisor in any case since they are operating under a fiduciary standard.
Disclaimer: The information in this blog post should not be considered tax advice or a replacement. They are solely provided for informational purposes. Please consult with a tax professional for any specific questions on your taxes.