Getting Exercised About Stock

I got stock at my startup on Friday, which I am exercising this weekend, but to my understanding nothing can he exercised until funding comes through and the stock price changes. Do you think the IRS will consider this as taxable income? Should I not bother exercising until we get the new share price?

All of these items are covered in great detail in 3.102: Common Stock and Options, especially Lesson 3: Stock Taxation. Since the recent Entrepreneur Minute on stock compensation, I have been inundated with stock tax questions, so it is certainly a topic that fires up startup employees, as well it should! The explanation below is technical and may not make sense the first time. I highly recommend you watch the class first to get the needed background.

First, were you granted an actual option to purchase shares or told you will in the future be granted an option? In the former case, you will have a “strike price,” which is the price you pay to purchase the shares (assuming you can early exercise them). In the latter case, your promise, often in an offer letter, will say that the options will be granted at the fair market value at the time the Board of Directors approves the grant. The need to issue at fair market value is effectively a requirement for you and the company to avoid tax trouble. It sounds like your company is closing a financing round, which will change your fair market value in most cases. It is likely the company will get a new Section 409A valuation (see the course for details) to determine the new fair value of the common stock.

Let’s now assume you were in fact issued the option already. The next question is whether you were issued an NSO or an ISO. I presume the latter. If the fair value of the stock has gone up, as it likely has because of the pending financing, you will be taxed at the time of exercise (purchase) on the difference between your strike price and the current fair market value. If your grant is an NSO grant it will be taxed as ordinary income. For example, if you have an NSO for 20,000 shares with a strike price of $0.02 per share and exercise them when the fair market value is $0.20 cents per share, you will have immediate taxable income of $3600 ($0.18 x 20,000). However, if your grant is an ISO, you will not be taxed immediately as ordinary income, but may have AMT tax on the spread in value depending on your tax bracket. Plus, you will must comply with additional requirements or you will instead be taxed like it were an NSO.

All clear? Probably not, which is why stock option taxation is such a horrid mess.

To add more pain to the process, you must also file a Section 83(b) election within 30 days of exercising the shares to avoid an even worse tax fate, which is being taxed on the spread in value between the strike price and the ever changing fair market value on each vesting date. The 83(b) election is mandatory for the best tax treatment and you cannot later fix a failure to file it on time.

Ultimately, you are choosing to make a certain outlay of cash and accept a certain tax hit if the value has gone up for the privilege of owning the stock now. (It is therefore always best to exercise stock options immediately when the fair value and strike price is the same, making the spread $0.)

The primary reason why exercising early matters is that capital gains rates are almost always lower than ordinary income rates for taxpayers in technology companies. Is the risk worth it? That depends on your assessment of the prospects for your company and your appetite to trade a little pain and risk for a lower tax bill in the future.

You should have someone help you model the numbers for your facts. In the worst case, you can simply hold your option until the company is purchased or goes public and do a “same day exercise,” where you buy and sell at the same time. You will pay a higher tax rate then, but at least you will have certainty.

See also: 3.102: Common Stock and Options

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