If you are new to stock options, it would be good for you to pay attention here. I am not qualified to offer tax advice, so this is all fiction based on my experiences of paying taxes in the Bay Area while working at startups and larger companies ...

It used to be that you could buy your options and hold them without any tax hit. After holding them for a year, if you could sell them, any gain was taxed at the long term capital gain rate. Since the long term capital gains rate (LTCGR) was much much lower than the short term gain, this strategy reduced the amount of taxes you paid. It was deemed a "loop hole" that the rich used and it needed fixing.

The fix was something called "Alternative Minimum Tax" or AMT. The way AMT works is it ignores the fact that you cannot sell your stock, and asks you to compute if you had sold the stock options you just exercised and treated all of that gain as ordinary income, how much tax would you have owed in that fictional scenario? Then it asks you to compare your tax bill in that fictional universe, and your bill without considering that fiction, and which ever is higher? That is how much you owe in taxes. It doesn't matter how you came by the stock, it could be through restricted stock plans (no cost to you to vest) or incentive plans. The difference between how much you paid, versus how much that stock is theoretically "worth" is treated like ordinary income.

What that means from a practical standpoint is that you are screwed either way. But if the stock becomes worthless you are doubly screwed. First you lose all the money you paid to exercise (the value is now zero) and second, while you can claim a capital loss, that loss can only be applied against an offsetting gain of "like" kind. So back when it was an AMT calculation you had to treat it like ordinary income, but now as a capital loss you can only offset other capital gains. The small concession is that you can consider up to $3,000 as a loss against your income (so you adjust your income down by $3,000 and you end up not having to pay the marginal rate income tax on that $3,000. If you're in California and an engineer making $100K+ annually that means you are probably in the 28% tax bracket paying 28% federal and 11% CA state tax, (39%) so you get to "keep" 39% of $3,000 or $1,170 that you would have paid in taxes.

So are you keeping score? You paid $3,000 in tax on an asset you could never sell, and you got to offset your income by $3,000 so you got "back" $1,170 of it, letting $1,830 of it evaporate into smoke.

You can get it back, dollar for dollar, if you have some capital asset that you're selling and seeing a gain on, then you can apply every dollar of your loss against that gain, up to all of your loss, and not pay any tax on that gain. (that doesn't work for offsetting AMT but does work for an actual capital gain, like sale of property or equity you were already holding).

The system is designed to take money you might have otherwise been entitled to out of your pocket and to put it into the general fund of the government so they can spend it poorly on their own programs (ok that is a bit cynical but seriously, I would be totally ok if they told me I had to give some to charity.)

If you don't have capital gains you want to offset, don't exercise your options until you can actually sell them. If they are going to expire before you can sell them, the safe play is to let them expire.