Startup Stock Options Tax HOWTO

Theodore Ts'o

This document may be freely redistributed according to the terms of the GNU General Public License.

Last revised February 17, 2000.

1. Introducton and disclaimer

Warning! I am not a lawyer, and I am not a tax accountant. The information in this document is correct, to the best of my belief, at this writing. It's distributed in the hopes that it will be useful, however, it shouldn't be used as financial advice. You should see a professional tax or financial advisor for more information. In particular, the tax laws may have changed, and they may be able to come up with other interesting strategies to save you tax money.

If you have stock options in a pre-IPO company, you should be able to afford professional advice. After all, that's why the Congress passes so many tax laws; they want to make sure that children of tax lawyers and accountants will never starve. :-)

I encourage you to do your own research, and to talk to your own professional tax lawyer and/or accountant. If you (or they) find any errors in this document, I'd appreciate hearing about them, so I can update this document to fix errors and to keep up with changing tax laws.

This document only discusses taxes in the United States. The tax treatment of options in other countries can and does vary. If you are a non-U.S. citizen, or you are working for a non-U.S. company, consult a tax accountant! Your mileage may vary.

You may find this document useful before you join a startup; being forewarned and forearmed when you commence salary negotiations can be a very good thing. In particular, take note about Restricted Stock Purchase plans.

All of the numbers in this document have been made up for pedagogical reasons. Any resemblance to numbers for any company or any employee of that company is accidental.

2. Basic Terminology: Different types of stock options

There are three different types of stock option plans:

  1. Incentive Stock Option (ISO)

    Incentive stock options (ISO's) are special in that the government has established certain criteria by which employees can receive stock options and receive preferential tax treatment.

    At most $100,000 worth of stocks (as valued at the date of grant) can be considered qualifying ISO's by the IRS. If the company wishes to give an employee more than this number of shares, they will be treated as non-qualified options. In order for stock options they must meet other qualification tests, such as expiring within ten years of the option grant. (XXX There may be other requirements for a option to meet the ISO requirements. Need to find them and include them here.)

  2. Non-qualified options (NSO)

    Not all stock option plans meet the qualifications required by the IRS to receive favorable tax treatment. Those that do not are considered non-qualified stock options (NSO's). NSO's are taxed as ordinary income as soon as they acquire a readily ascernabile Fair Market Value. (This usually means that it's trading on some options exchange as a marketable security.) If they are exercised before acquiring a FMV, any profits arising from exercising NSO's are treated as ordinary income.

    There will not be much discussion of NSO's in this document, since they relatively simple and most companies try very hard to make their stock option plans meet the ISO plan requirements, since it provides their employees with much more favorable (if complicated) tax treatment.

  3. Employee Stock Purchase Plans (ESPP)

    Employee stock purchase plans allow employees to purchase stocks at a discount. Typically the employee is allowed to disgnate some ammount (usually from 1 to 10%) of their paycheck to go into an account for some period of time, called the offering period. At the end of that period, the money in that employee's account is used to purchase shares at a discount. One common way this is done is to look at the stock price at the beginning and at the end of the offering period, and then take the cheaper of those two dates. That price is then usually discounted by some percentage, say 10 or 15 percent. (XXX The IRS has rules about what is allowable in employee stock purchase plans. Investigate what they should be.)

    Since they are structured so that at the end of the offering period, stocks are delivered to the employee, many employees don't think of ESPP as an option plan. But since they use options as their underlying legal basis, they are taxed accordingly. ESPP's which meet the IRS's legal requirements also receive favorable tax treatment.

3. 3 Magic Dates

There are three important dates when considering company option plans:

  1. Date of Grant

    This is the date on which the company grants you the right (possibly subject to some vesting schedule) to purchase shares of the company stock at some price, known as the strike price. The options will expire at some point in the future, which is known as the term date or the expiration date. (Incentive Stock Options must expire within ten years of the grant date, by IRS regulations.)

    Basically, you don't have to do anything on this date; the company gives you options, and you hope the value of the stock goes up. In a pre-IPO situation, typically the stock strike price will be at some very cheap amount --- anything from 10 cents to a few dollars. If and when the company IPO's the hope is that it will do so at an IPO price that is sustantially higher ($10-20 is typical). Before or after the IPO, your company may engage in one or more stock splits. Options generally have language which state that when a stock split happens, both the number of shares you are entitled to purchase, and the strike price are appropriately modified. So if you have an option to purchase 10,000 shares at a strike price of $2, and your company does a two-for-one split, after the split you will have 20,000 shares at a strike price of $1.

    There are no tax consequences associated with being granted ISO or ESP options. For NSO's, if they are trading on the open market (or otherwise have a fair market value), their FMV is taxable as ordinary income when they are granted to you. (If they do not yet have a FMV, you won't become liable for taxes until they do.)

    (Note that in some countries all options are treated like NSO's. Non-qualified stockoptions can have extremely painful tax consequences for some employees, especially if the stock price of the company later sinks below the option strike price. In this case, the options are "under water" and are useless, yet the employee still gets taxed on the value of the option at the time it was granted to them. This is a *big* advantage of ESPP and ISO plans, since they don't have this problem.)

  2. Date of Exercise

    This is the date at which you use your options to actually purchase stocks. You write your company a check, and then you get some number of shares of stock. In some cases, the sale of these stocks may be restricted --- either because of a lockout period or because they were purchased under a Restricted Stock Purchase (RSP) plan. More on this later.

    There are no tax consequences at this point for normal taxes, but exercising incentive stock options may have consequence for the AMT --- the Alternative Minimum Tax system. More on this, again, later.

  3. Date of Disposition

    This is the date at which you cease to own the shares of stock purchased via a stock option purchase. This is is usually due to your deciding to sell the shares of stock, but there are other times when this can happen. Other types of dispostion include giving the stock to someone else (say, to a family member, or to a charitable organization.)

    This date is important for stocks which you purchase on your own, since it controls whether the profit or loss from those stocks are treated as long or short-term gain. However, it is doubly important for stocks which are purchased via options given to you by your company, since the government wants to treat some portion of your gains as salary --- and taxable as ordinary income --- instead of as long-term or short-term capital gains.

    (Note that even if there is no difference in the rate at which short-term capital gains and ordinary income are taxed, the distinction is still important, since capital losses can be used to offset capital gains, but only a very limited amount of capital losses can be used to offset ordinary income. So as a general rule, from the point of view of tax avoidance strategies, long-term capital gains are better than short-term capital gains, which in turn is better than ordinary income.)

    For ISO and ESPP plans, if you have held the stock for at least two years after the option was given to you, and at least one year after you exercised the option (i.e., purchased the stock at the strike price) before disposing of the stock, then that disposition is considered a "qualified" disposition, and you will be taxed on it at the long-term capital gains rate of 20%.

    If you dispose of the stock before this two-year/one-year period, then it is considered a "non-qualified" disposition, and the profits associated with selling this stock are considered ordinary income. (And in the case of ESPP, the company must report the gain to the IRS on the W-2 form, along with your other salary compensation information.) Note that this means that giving shares of stock (which counts as a dispostion) before the qualification period is up can have very negative tax consequences for you!

    For non-qualified options, the gain (or loss) of stocks is considered as normal capital gains.

4. Three magic prices, and three magic differentials

  1. Option strike price

  2. Fair market value of stock when option is exercised (i.e. stock is purchased)

  3. Value of the stock when it is sold.

  1. The difference between the strike price and the fair market value of the stock. (The spread)

  2. The difference between the purchase price of the stock and the sale price of the stock. (Total gain)

  3. The difference between the fair market value of the stock at the time it was purchased and the sale price of the stock. (Gain/loss in excess of the spread).

        3 ==================>   $50   +==+  =====   =====      
           Stock price when           |##|    ^       ^
           shares are finally         |##|    C       |
           sold.                      |##|    |       |
                                      |##|    v       |
        2 ==================>   $10   +==+  =====     B
           Stock price when           |XX|    ^       |
           option was exercised       |XX|    A       |
                                      |XX|    v       v
        1 ==================>    $1   +==+  =====   =====
           Option Strike price        |**|
Key:	* Paid to purchase the stock
	X The "spread" between the stock price and the option strike
		price (AMT Taxable when you exercise)
	# Gain/loss in excess of the spread (AMT Taxable when you sell)

The XX and ## regions are taxable under the regular tax system when you sell, either as ordinary income, or as long-term capital gains if you meet the two-year/one-year qualification holding period (and the shares were purchased using ISO or ESPP options).

Disclaimer: The prices in this example are purely for illustrative purposes. Your company's mileage will certainly vary!

They also assume the stock gains in value between when the option was exercised and when it is finally sold --- which of course can't be guaranteed! (Although in the case where options are granted pre-IPO, and the option is exercised just before the IPO, and the shares are sold post-IPO, employees certainly hope this will be the case!)

5. The dreaded AMT

There are two different tax systems. One is the regular tax system, which most people are familiar with. The other is the Alternative Minimum Tax (AMT) system. You must calculate both, and pay whichever is larger. The AMT is designed to make sure that the rich pay "their fair share" (whatever that means).

If you have ISO options, you have to worry about the AMT. (ESPP options and non-qualifiying options don't have AMT consequences.)

Basically the way the AMT works is that some deductions (including the standard personal exemption) are excluded from the AMT calculations. Also, some items which aren't counted as income (such as "profits" from exercising ISO options) can also adjust your AMT income. Your AMT income (minus an AMT exemption of 45,000 if married, 37,500 if single) is taxed at a 26% rate up to $175,000 and 28% rate beyond that. However, the AMT exemption gets phased out (reduced) by 25 cents for each dollar that the AMT income exceeds $150,00 if married, or $115,200 if single, with the AMT exemption completely eliminated by the time AMT income hits $330,00 if married, or $247,500 if single. If you joined a startup early in its life cycle, and it's not hard to hit that limit!

So for most purposes, assuming a marginal rate of 28% is a good simplifying assumption for making back-of-the-envelope calculations. (By the way, it's amusing to note that with only two tax brackets that very close together, the AMT system is basically a "flat tax" system. This is especially true after you've blown past the AMT exemption phaseout limits!)

When you exercise ISO options, the spread between the strike price and the fair market value price of the stock at the time of the purchase is considered an AMT "adjustment", and is taxable under the AMT system.

For example, suppose you have 10,000 options with a strike price at $1/share, which were given to you when you joined the company as a startup, and the company IPO's and the stock is now trading at $21/share. You now decide to exercise your options. You will pay $10,000 to your company, and receive 10,000 shares. Those shares are now worth $210,000 on the open market. Therefore, $200,000 will be subject to the AMT, which means an AMT adjustment of roughly $56,000.

(You really have to calculate your taxes both ways to find out how much extra you will need to pay due to the AMT. A computerized tax program is essential for doing these what-if calculations. In practice it won't be the full $56,000 extra, since the AMT exemption will still (partially) apply, and because in the AMT world, your salary income is also taxed at the lower 28% AMT tax rate. Remember, with the AMT you are essentially calculating your taxes two different ways, and paying whichever is greater. For this reason, you will be able to exercise some number of ISO options without pushing your AMT taxes above your regular taxes. Calculating this number is essential for doing good tax planning, since it is probably a good idea to exercise at least that many shares each year; since you do want to exercise your options before they expire --- or the stock market bubble busrts! :-)

In an IPO situation, consideration of AMT taxes can be very important, because of lockup agreements. This limits when you can sell your shares of stock; typically, as an employee, you're not allowed to sell shares provided to you by the company for 180 days after the IPO date. So if your company goes public close to the end of the year, and you exercise your options shortly before the IPO, you could find yourself in a situation where on the next April 15th, you will have to pay a huge amount of AMT taxes to the IRS, but you won't be allowed to sell any of your shares of stock in order to cover the taxes. This can be bad; very bad. Planning is therefore very important. In some cases, if the spread is large, purchasing $10,000 worth of stock might mean several hundred thousand (or even millions) of dollars in tax liability. Of course, this means that eventually you will probably do very well, so you won't catch me weeping that many tears for you --- but if you don't have that kind of money available in the short-term, you could put yourself into a very tight tax squeeze come April 15th.

When you finally sell the shares, as far as the AMT is concerned, you're only taxed on the difference between the fair market value price of the stock when you purchased it, and the sale price of the stock. That's because you've already been taxed (as far as AMT is concerned) on the option spread amount already:

          ==================>    +==+
           Stock price when      |##|
           shares are finally    |##|
           sold.                 |##|
          ==================>    +==+
           Stock price when      |  |
           option was exercised  |  |
                                 |  |
          ==================>    +==+
           Option Strike price   |  |

6. When to exercise ISO's

In general, assuming that you feel good about your comapny's long-term prospects, and assuming you can afford to purchase the stock at the option price, it is usually to your advantage to exercise options as soon as possible. This minimizes the option spread which is an AMT taxable item, and it starts the clock on the long-term capital gains. Let's look at an example to illustrate this point.

Suppose you have 10,000 options with a 75 cent strike price which have just vested, and the fair market value of the stock is now 1 dollar (for pre-IPO stock, this is normally determined the strike price of options granted to recent hires). In order to exercise all of your options, you will need to write a check to your company for $7500. The spread between the option strike price and the value of the stock is $2500, and that would be subject to an AMT adjustment. It's likely that this amount would not trigger AMT, and even if it did, in the worst case your additional AMT liability would be 28% of $2500, or $700.

A year later, your company IPO's at $12 and then immediately rises to $24/share. (Even before the Internet stock mania, underwriters usually price the stock to go up by at least 50-100% above the IPO price. If this doesn't happen, it's often considered a "failed" IPO.) A year later, the stock has risen to $30/share, and as your lockup period as expired, you sell your stock. This gives you a profit of 10,000 times $29.25, or $292,500, which is taxable at the 20% long-term gains, since you've met the 2-year/1-year qualifying holding period. So, you pay $58,500 in taxes.

If instead you didn't exercise your options, and simply waited until a year after the IPO to "flip" your options --- that is, exercise them and then immediately sell the shares, you will still make a profit of $292,500. But since you didn't meet the qualifying holding period on the holding period, that gain is taxable as ordinary income, which is happily 36%, and so you would owe $105,300 in taxes.

As another scenario, suppose you waited until just before the IPO to exercise your options. This might be because you weren't sure when your options vested whether your company would be successful or not, or perhaps because at the time, you couldn't come up with the $7500 necessary to exercise your options. So you wait a year, and only exercise your options just before the IPO. When you finally sell the stock a year later, you would still get to treat the $292,500 gain as long term gains, and only pay taxes on it at the 20% rate instead of the 36% rate. However, the options spread when you exercised the ISO's is now $11.25/share, and so in the year that you exercised, you would have an AMT adjustment of $112,500, and would have to pay an AMT tax liability of approximately, $30,000. (You do get the AMT tax back eventually, though, as a tax credit in future years; see the "AMT Tax Credit" section for more details.)

Thus in general, exercising ISO's earlier is beneficial from a tax point of view. So if you're fairly sure that your company will survive (remember, relatively few startups survive to actually go public), holding stock in the company is better than holding options. The closer the company is to its IPO date, the more the risks go down, but at the same time, the more the tax benefits to exercising also go down, because of the AMT tax hit.

One suggestion: if you are a very early employee, you might want to ask for *stock* instead of *options* when you do your salary negotiations. As an early startup employee your salary won't be that great anyway, and that eliminates the need for you to have to put money in when it comes time to you exercise your options. It also allows the long-term capital gains clock to start ticking right away. Sometimes, the best time to exercise ISO's is "never", and that's something to keep in mind when you are negotiating your compensation before you join a startup.

7. Restricted Stock Purchase Plans

Restricted stock purchase plans are a way that a company can allow you to exercise your incentive stock options early, before they have vested. The catch? You're not allowed to sell your stock until the options they were purchased with would have vested, and if you leave the company, the company has the right to buy the shares back at the option strike price.

What's the advantage is using an Restricted Stock Plan? It allows you to purchase the stock before your stock options have vested. In effect, it decouples the decision of when to exercise your options with their vesting date. As we've seen above, exercising your stock options well before the IPO date can be a very good thing from a tax perspective.

In order to get this advantage, however, you must file an 83(b) election IRS with the IRS within 30 days of early-exercising your stock. It should be sent via certified mail, and when the IRS sends back a date-stamped of your letter, you will need to send a copy of it along with your 1040 tax filing.

Why is this 83(b) election needed? Normally, the IRS doesn't consider that you've started owning a stock if you're restricted from selling it or the transaction might become reversed under some circumstances (such as your leaving the company). Basically, it's fascinating philosophical question: do you "own" something if you're not allowed to sell it and someone has the right to give you back your money and respossesss the stock? IRS says no. However, if you file an 83(b) election statement, you're basically saying for tax purposes, you wish to be treated as if you really owned the stock. This starts the long-term capital gains clock ticking, which is good, but it will likely make you subject to AMT.

What's the disadvantage to taking advantage of an RSP? To the extent that you pay AMT, you need to have the money available. If the stock has not IPO'ed yet, or is subject to a lockup period, you may not be able to sell shares in order to pay the taxman on April 15th. Also, if you leave the company before the shares vest, the company can (and probably will) buy back your non-vested shares at the option price. However, you're still out the AMT liability.

Restricted Stock Purchase plans are best for employees that join a company less than 12-18 months before its projected IPO date, since it allows them the option to exercise their options before they have fully vested.

Because of the very large AMT tax liability that may hit, especially if the RSP window opens just before the IPO, employees may elect to only early exercise part of their options. This can also reduce the window by which you might get screwed if you leave the company before all of your shares have vested. For example, if you joined the company 6 months before the IPO, and 25% of your options vest after a year, just before the IPO, you might choose to early exercise 25% of your options --- the ones which vest 12 months after your date of hire (and 6 months after the IPO). You wouldn't be able to sell the stock for six months anyway, so the fact that the stock is restricted doesn't change when you could sell the stock. For those six months, though, if you get fired, you might lose all of the benefit of the stock gains, but still have to pay the large AMT tax liability --- which is good reason not to early exercise more stock options.

If instead you had early exercised 50% of your stock options, your AMT tax liability would be doubled, and for two years you wouldn't be able to leave the company without losing some of your shares. So in many cases it doesn't pay to exercise all of your options under an RSPP. Consider carefully how much AMT you might have to pay before you exercise.

8. AMT Tax Credit

Here's one more wrinkle to throw into your tax planning strategy kit. If you pay AMT tax, the additional AMT tax over your regular taxes can be carried forward and used as a tax credit in years where your regular taxes exceed the tax as calculated via the AMT system.

Consider this table below:

Regular tax 5,000 7,000 8,000200,000
AMT Tax80,000 5,00012,000100,000
AMT Tax credit --- 2,000 --- 77,000
Tax you owe80,000 5,00012,000123,000
AMT Tax Credit carryforward75,00073,000 77,000 0

In 1999, because you exercised some ISO's, suppose you incur an 80,000 AMT tax liability. Because the AMT is more than your regular tax, you have to pay the AMT tax. However, the difference between your regular tax and your AMT tax can be used to offset taxes in future years.

In 2000, suppose you don't exercise any more options and you haven't sold any stock; but the company has given you a raise since it's now out of the startup phase. So your regular tax is figured to be $7,000, and figuring your AMT tax at the 28% rate, you find that your AMT tax is $5,000. Since the AMT tax is lower than your regular tax, you only have to pay the regular tax of $7,000. But wait! You can use $2,000 of your previously paid AMT tax credit to lower your tax bill to the AMT tax of $5,000.

In 2001, suppose you exercise a few more shares, and so you need to pay $12,000 because of the AMT. As in 1999, the $4,000 in excess of your regular taxes is credited to your AMT Tax "Credit account", so you now have $77,000 to offset future taxes.

In 2002, you finally sell your shares of stock purchased via your incentive stock options. This causes a huge regular tax bil, but your AMT tax bill is surprisingly smaller. That's because the cost basis of your shares for the purpose of AMT calculations is larger, to take into account that some of that gain was taxed by the AMT tax system in 1999, when you exercised your stock options. This means there's a $100,000 differential between your regular tax bill and your AMT tax bill, and so you can use your AMT taxes paid in previous years to offset your taxes, so that you only have to pay $123,000 in taxes.

This means that you can also think of the AMT tax system as an involuntary loan to the goverment; for the purposes of exercising incentive stock options, it's really as if the government is demanding the tax on some part of your future profits *now*, instead of when you finally sell the stock. So assuming that you can come up with the money, it's not as if the money you had to pay because of the AMT is gone; you will eventually get it back when you sell the stock, assuming that the stock has appreciated as you expect. You just lose the interest on the AMT tax money, and you take the risk that you might not be able to recapture the AMT tax money if your company folds or its stock price tanks.

Note: There has been some discussions in Congress to completely eliminate the AMT. I'm not sure what will happen to people who paid AMT taxes in previous years after the AMT disappears; if this happens, it may be that your chances of seeing that money will become roughly equivalent to your chances of seeing all of the money which you were forced to sink into the Social Security system (i.e., slim to none).

9. State Taxes

When doing tax planning, it's important to consider the effects of state taxes as well. For example, in Massachusetts, short-term capital gains are taxed at 12% instead of the long-term and ordinary income rate of 5%. This very steep tax rate on short-term capital gains means that it may be advantageous to "flip" stock options to raise cash (since this is taxed as ordinary income, than to sell ordinary stocks which are subject to short-term capital gains.)

Other states, such as California, also have an Alternative Minimum Tax system. It's important to know how a particular state's taxes are structured if you want to make the best plans. A local financial planner may be very useful to you here.

10. Summary

What does this mean if you're starting to work for a startup? Well, a lot of things. If you want to prevent enriching Uncle Sam unnecessarily by potentially hundreds of thousands of dollars, it's important to do some advance planning, up to and including before you even start working for the startup.

Things to consider when you enter the salary negotiation process? First of all, stock options are nice, but stock is nicer. If the company has just gotten started, the difference might not seem like much --- after all, what's the difference between getting granted stock that vest over four years, and being given stock options that vest over the same period, but for which you have to pay a dime per stock before you actually get the stock? From the point of the view your eventual winnings should you win the IPO lottery, not that much. But from a tax situation, it can make a huge amount of difference. The long-term holding period clock starts ticking right away, and you don't have to worry about all of the issues surrounding AMT and ISO's. So if you're getting involved early, and you're someone whom the company needs fairly badly, by all means, try to insist on getting stock instead of stock options.

If the company won't give you shares outright, but insists on giving you stock options (and if you're joining the company later in its pre-IPO phase, this won't be surprising), ask if the company has a restricted stock purchase plan. If the company doesn't have one, insist that the company set up one. It doesn't cost the company that much money; it's mostly lawyer's fees, and it's a huge benefit for employees that understand how to use it. If the company does have a RSPP, insist that that the company open up a RSPP purchase window shortly after you join the company. That way, you minimize or eliminate any AMT, and you can start the long-term capital gains clock running. Of course, you do take the risk that if the company completely tanks, you might be out that money. And, if the company takes longer than you expect before it IPO's, you might not see the money for a long time. On the other hand, if you are joining a company that is likely going to go public within the next year, you should strongly consider asking for and taking advantage of an RSPP.

Finally, remember that despite this paper's focus on long-term planning, you shouldn't count your chickens before they hatch. Until you actually exercise your options and then actually sell your company's stock, you don't really have the money. Instead, all you have is fancy paper that you can use to wallpaper your bathroom if your company or its stock goes bust. Money should only be spent based on what you have, not based on your expectations, since sometimes expectations don't turn out the way you or anyone else expect.

11. References

J.K. Lasser's Your Income Tax 2000

Kiplinger Tax Cut Tips

Private communications with Frank Cesario (my brother-in-law, and a tax accountant. Thanks Frank, for your patience in explaining some of the finer details of AMT tratement and some strategies with dealing with the AMT.)

The web site also has useful information concerning the tax treatment of equity compensation. (n.b. They're also trying to hawk their upcoming book, "Consider Your Options", which purports to cover this topic; I haven't read the book, so I can't give it a positive or negative recommendation.)

Robert R. Pastore has a book, STOCK OPTIONS: AN AUTHORATATIVE GUIDE TO INCENTIVE AND NONQUALIFIED STOCK OPTIONS (1998) which is quite good. The one shortcoming of the book is that it doesn't really cover the startup situation well, where the numbers make certain tax strategies more applicable than others. Since this HOWOTO covers this situation ratherly exhaustively, Pastore's book is a good complement to this writeup. In particular, this book as a very good analysis of the question of whether it makes sense to "exercise and flip" or "exercise and hold" ISO's in a post-IPO situation, which is a very complicated question, depending on your tax bracket, projected future returns of your company's stock, and so on. This book is published by PCM Capital Publishing, in Sausalito, California.