byEvan Stephens, tax manager at Sensiba San Filippo
In today’s start-up culture, it’s common for companies to offer employees the opportunity to own stock in the business. While most folks know the basic benefits of receiving stock, many employees are taken off guard by the tax implications that follow.
There are two types of stock options, Incentive Stock Options (ISO) and Non-Qualified Stock Options (NQSO). Profit from ISOs have the potential to be taxed as long-term capital gain, which is a considerably lower rate than NQSOs, which are generally taxed as ordinary income.
Incentive Stock Option (ISO).
Employees with ISOs have some specific tax benefits that other options lack. Unlike NQSOs, taxes are generally deferred until the stock is sold, rather than exercised. Any proceeds from an exercise or sale become subject to taxation at the lower, long-term capital gains rate rather than ordinary income rates.
However, there is a caveat to be aware of. The difference between exercise price and the fair market value of the stock on the day of exercise must be calculated as part of Alternative Minimum Tax (AMT) adjustment. For companies with substantial growth, that number can be very large — something many employees fail to account for come tax season. Essentially, the employee will be taxed on the profit they might have made if the stock was sold on that day. In some cases, it’s recommended to sell a portion of stock in order to cover the associated AMT taxes.
Employees can benefit from a Section 83(b) election, which allows an employee to “exercise” stock options at the date of (or near) the grant when exercise price is equal to the fair market value. That means there is no AMT adjustment to report and no added tax liability. Since the stock has yet to vest, this election treats the option as exercised solely for tax purposes. This special election also begins the holding period for long-term gain treatment, meaning holding can start earlier than the actual exercise date. This achieves the potential for long-term gain treatment on a sale at an earlier date. However, the employee has to have the money to buy the stock on the date they make the election.
Non-Qualified Stock Option (NQSO).
NQSOs are essentially any stock option that does not meet the ISO qualifications. When an employee exercises a NQSO (or NSO), the spread between exercise price and the fair market value on the date of exercise is reported as ordinary income. This shows on the employee’s W-2 and the expense is recognized by the employer. Employers are required to withhold both federal and state taxes when an employee’s option is exercised. Companies have a couple of methods to choose from, but the most common is to require the employee to pay the withholding amount in full at time of exercise. This is done by “holding back” some of the stock value in order to pay the withholding taxes. The company must also pay their share of employment taxes at the time of exercise.
If the employee exercises the option and decides to hold the stock, the fair market value on the date of exercise becomes the cost basis (price point) for when that stock is sold later on. The difference between the sell price and the cost basis is treated as capital gain/loss and is subject to a 20% favorable rate, if long term.
NSQO holders can benefit from an 83(b) election and begin their holding period on an earlier date than exercise date. They will still have to pay for the stock out of pocket and risk paying tax on gains if their exercise price does not match the value at grant date.
If the employee exercises their stock option and sells immediately, referred to as same-day sale transaction, there is usually no gain or loss on the sale of the stock. In this case, everything is reported under ordinary income since the sell price of the stock is close, if not the same, as the fair market value of the stock at that time.
Evan Stephens is a tax manager at Sensiba San Filippo. He specializes in tax planning, compliance, and tax consulting for startups, technology and software companies. He can be reached at 408-286-7780 or [email protected].
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FAQs
Stock options overview. First things first. A stock option is an option to buy shares of stock, not actual shares of stock issued to you. Roughly speaking, if you are offered a stock option grant for 1000 shares at a $0.20 strike price, you have the option to buy 1000 shares of stock for $200 (1000 * 0.20).
How do stock options work at startups? ›
Startup stock options are a form of equity compensation that startup founders offer to their employees. In essence, they are an agreement between the employer and employee that gives the latter the right (but not obligation) to buy company shares in the future at a pre set purchase price.
Are startup stock options worth anything? ›
In cases where a startup is growing over time or heading to a successful exit, employees can sell their stock for more than they paid to exercise their options, and they make a profit. The bigger the difference is between the initial issue price and the eventual selling price, the more money the employee makes.
What is the rule of 65 for stock options? ›
Rule of 65: The Award recipient meets the “Rule of 65” if the Award recipient terminates employment on or after age 50, but before age 55, and the sum of the Award recipient's age and years of service add up to 65 or more as of the employment termination date.
What is the 100K rule for stock options? ›
The 100K Rule[1] states that employees cannot receive more than $100K worth of exercisable incentive stock options (ISOs) in a calendar year. Any additional ISOs over the $100K threshold are treated as non-qualified stock options (NQOs) in the eyes of the IRS.
How do stock options pay out? ›
Stock options aren't actual shares of stock—they're the right to buy a set number of company shares at a fixed price, usually called a grant price, strike price, or exercise price. Because your purchase price stays the same, if the value of the stock goes up, you could make money on the difference.
Are stock options really worth it? ›
Employee stock options represent a right that you have to exercise your options and receive your stock, but not an obligation. There is value in employee stock options when the market price is higher than the grant or strike price, but while you might make a lot of money off of them, you also might not.
What happens to stock options when a startup fails? ›
Nothing in particular happens to employee stock options if the issuer fails to go public, they simply persist as stock options according to the terms of the option plan and option grant. That means they continue vesting, vested (and in a few cases unvested) options can be exercised at any time and…
Should I exercise stock options startup? ›
Likely, the company won't reach a liquidity event until after series B funding, so exercising your stock options early can be risky. If you decide to exercise them early, it's best to do so in stages and spread out the risk of holding onto all of your equity at once.
Is it risky to buy stock options? ›
Options are generally risky, but some options strategies can be relatively low risk and can even enhance your returns as a stock investor. Like stockholders, owners of options can enjoy the potential upside if a stock is acquired at a premium to its value, though they'll have to own the options at the right time.
Trading options for a living is possible if you're willing to put in the effort. Traders can make anywhere from $1,000 per month to $200,000+ per year.
What is a good amount of stock options? ›
Non-Exec Employees
In terms of what value of options to give away to non-executive staff members, the general recommendation is that senior level members get granted 50 % – 90 % of their salary in options, medium level staff member 25 % – 50 %, and junior staff members get granted 10 – 25 %.
How much money should you have before trading options? ›
If you're looking to get started, you could start trading options with just a few hundred dollars. However, if you make a wrong bet, you could lose your whole investment in weeks or months. A safer strategy is to become a long-term buy-and-hold investor and grow your wealth over time.
How much can you realistically make with options? ›
How much money can you make trading options? It's realistic to make anywhere between 10% – $50% or more per trade. If you have at least $10,000 or more in an account, you could make $250 – $1,000 or more trading them. It's important to manage your risk properly by trading them.
Can you make a living selling stock options? ›
Do people sell options for a living? Yes, many traders sell options for a living. However, whether an options writer can earn enough income selling options heavily depends on their portfolio size and risk tolerance.
How many stocks should I own with $100 K? ›
One rule of thumb is to own between 20 to 30 stocks, but this number can change depending on how diverse you want your portfolio to be, and how much time you have to manage your investments. It may be easier to manage fewer stocks, but having more stocks can diversify and potentially protect your portfolio from risk.
What happens to stock options when a startup is acquired? ›
Stock Options
Exercised Shares: Generally, exercised shares are either paid out in cash or converted into common stock shares in the acquiring company. A cash payout will cause a taxable event while a share conversion may not depending on the deal structure and if you hold or sell the stock once granted.
Can you sell startup stock options? ›
It's important to understand what you can and cannot sell. You cannot sell stock options but you may be able to sell shares in your company. That means you'll first need to exercise your stock options and turn them into shares before moving forward with a sale.
