Startup Equity 101: Tax Implications
By: Andrew Wei
Tags: Equity, Taxes, Startup

Stock Options Taxation

NSOs vs ISOs

As I mentioned earlier, stock options come in two flavors: incentive stock options (ISOs) and non-qualified stock options (NSOs). The primary difference between them is how they are taxed. ISOs are eligible for some preferential tax treatment, but are subject to certain restrictions. NSOs, on the other hand, are much more straightforward.

The differences are too complex to detail in this post, however you can read more about the differences here. NSOs are simpler than ISOs and do not receive special tax treatment, so I will use them as the basis for this discussion. Throughout this section, I’ll use the term “stock options” and NSOs interchangeably.

Like RSUs, stock options are not actual stock, and therefore you are not taxed when you receive your options. Once you exercise your options however, you’ll be taxed for your receipt of the stock. Stock options follow the same general rule I mentioned at the beginning of this article — stocks received as a part of the exercise of options are taxed as ordinary income, and any stock sold thereafter is taxed as capital gains.

One thing you’ll realize is that unlike RSUs, options allow you to control when you receive your stock. This flexibility can come in handy when trying to minimize the tax impact of the equity you receive.

Taxation on Options Exercise

If you remember back to part 2 of this series, the value of your options equals the stock value minus your exercise price. When it comes to taxation however, the IRS is only interested in the 409A valuation, or fair market value (FMV), of your stock. In other words, the IRS considers your option value to be equal to the FMV minus the strike price. When you exercise your options, you will be taxed on that difference. (Note that once the company becomes public, FMV goes out the window and is replaced by the public stock price.)

For example, let’s say you were granted options at a $2 strike price. A year later, you vest 10,000 options, and the FMV of the company goes up to $5. If you decide to exercise your options then, you would pay $20,000 to receive 10,000 shares, and recognize ($5 — $2) * 10,000 = $30,000 in ordinary income when you exercise your options.

Continuing on, let’s say the company IPOs a year later at $10/share. If you sell your stock then, you’ll receive $10 * 10,000 = $100,000 in cash, of which ($10 — $5) * 10,000 = $50,000 will be recognized as capital gains.

An example of how options are taxed as they are exercised and sold.

Using the same example, let’s say you instead wait until after the company IPOs to exercise your options. In this scenario, the stock price at the time of exercise is now $10, and you end up recognizing ($10 — $2) * 10,000 = $80,000 in ordinary income. Since the company is now public, you can sell the shares immediately — if you do that, you’ll convert your shares to cash and recognize no capital gains since you sold it at the same price you received it at.

Note that in both scenarios, you’re still recognizing $80,000 worth of additional income. The main difference between the scenarios is what portion of it gets taxed as ordinary income vs capital gains.

Early Exercise and Section 83(b) Election

Since the capital gains tax rate is less than the income tax rate for most people (assuming you’re able to take advantage of long-term capital gains taxation), it makes sense that the earlier you exercise your options (while the FMV is still low), the more beneficial it would be for you, tax-wise. What if you’d be able to exercise your options before you even vested them? If the strike price of your options was equal to the FMV of the stock, you could exercise your options and any future appreciation in value would be taxed as capital gains instead of ordinary income!

If your company offers it, you may be able to “early exercise” your options, also known as an 83(b) election. The 83(b) election essentially allows you to pay upfront to exercise your options before they vest, and then you’ll receive shares of stock instead of options when they do vest. Since options grants are usually issued with a strike price equal to the FMV at the time of the grant, the 83(b) election would give you the opportunity to convert your options upfront and avoid incurring any income tax. Any future gains would then be taxed as capital gains instead of as ordinary income.

For early employees of a startup where strike prices are really low, it may make sense to early exercise your options grant in order to lock in potential tax savings. If you’re a later-stage employee however, the higher strike price could make it prohibitively expensive to early exercise, and would also expose you to more risk if the company takes a downturn.³