Incentive Stock Options and Taxes

Having spent two years at Cloudera, starting as the third employee and leaving with the company between 40 and 50 employees, I’ve learned a thing or two about the tax law and how one can optimize the exercise and sale of shares to avoid taxes.

Disclaimer: I Am Not a Tax Expert

I am not a tax expert.  You should consult a tax specialist if you ever need to optimize for the exercising and selling of stock options.  Much of what is covered here was learned in Consider Your Options, which I recommend reading if you ever are granted stock options.

Also, in no way do the example numbers listed below reflect on Cloudera’s stock option grants or fair market value.  The numbers below are completely arbitrary, even numbers to make calculations easy.

Background

Before we start talking about exercising and selling I should cover some terminology and common practices.  Tech startups usually give stock options to their employees in exchange for less salary.  There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs).  Most tech startups, especially in the early days, will issue ISOs to their employees.  This post only covers ISOs, not NSOs.

In most startup cases, especially for engineers and business owners, part of an employee’s offer for employment will be a stock options grant.  A grant includes an amount of stock options, a strike price, and a vesting schedule (more below).  A stock option is an option to buy a share of the company, and the strike price is the amount each share costs if you decide to exercise your options and purchase shares.  Earlier grants will have smaller strike prices and more shares than later grants, assuming the company is doing well.  As a company grows and succeeds, risk of employment is lower and valuation is higher, hence less shares and larger strike prices will apply.  It’s possible to get additional grants from the company, perhaps in the event of an additional funding round or in the event of performance compensation.

The fair market value (FMV) of the company is the amount of money each share is worth at a given time.  This number changes every time a company raises a round of funding, and even possibly on anual or semi-anual schedules.  For example, a startup that has seen only one round of funding (series A) might have a FMV of $.15 per share.  Whereas a startup that has seen two rounds of funding (series A and B) might have a FMV of $1.00 per share.  The numbers outlined here for Series A and B companies are completely arbitrary.

Option grants typically include a vesting schedule as well.  A vesting schedule dictates when an employee is allowed to exercise options.  Most vesting schedules are the same across tech startups.  Typically your granted stock options vest over four years.  During the first year none of your stock options will vest.  Then, at your one year anniversary 25% of your granted stock options will be vested and available for exercise.  Then, each month 1/48th of your granted stock options will vest.

Timeline, From Options Grant To Money

Here’s the timeline of events that will likely occur during the time an employee receives a grant and sells a share for cash.

  1. Grant received from employer
  2. Vesting period met (e.g., after one year)
  3. Stock option exercised – employee must pay company # of shares X strike price; employee owns share
  4. Exit — either the employee sells their share on a market (public or private), or an acquiring company converts an employee’s shares to cash or the acquiring company’s shares

Short-term Capital Gains vs. Long-term Capital Gains

The taxes paid when a share is sold, either to a public or private market, depend on the duration and timing of exercise and sale.  Short-term capital gains taxes are taxes paid for shorter term investments, maxing out at 39% (like income tax).  Long-term capital gains taxes are taxes paid on longer term investments, which is currently 15% and rumored to increase to 20%.  One needs to optimize their exercise and sale schedule to try and avoid paying short-term capital gains tax.  In order to avoid paying short-term capital gains on ISOs one needs to hold a stock option for at least a year, exercise, then own the share for at least a year before selling the share for cash.  Notice that at a minimum the described practice will require at least two years between the time of grant and the time of sale for cash.  So let’s say I’m granted 100,000 shares at a strike price of $.10.  If I were to purchase 25,000 shares exactly a year after my grant, I would pay my employer $2,500 (shares X strike price) and be able to sell those shares exactly a year later to avoid short-term capital gains.  If either the exercise happens before a year, or the sale happens before two years (from the grant period), then short-term capital gains will apply.  Note that often companies won’t let employees sell shares for cash unless the company is public.

So again, if you believe your company will do well you should exercise options at least a year after their grant date, and don’t plan to sell those shares for cash for at least an additional year, totaling at least two years of total investment.

Avoiding Alternative Minimum Tax (AMT)

The other trap to avoid when planning an exercise and sale schedule is alternative minimum tax, or AMT.  AMT is wildly confusing and I only understand some of its circumstances.  Think of the AMT as being a way for the federal government to tax you more in certain circumstances.  One such circumstance is in the event of exercising options.  Normal tax law doesn’t apply at all to the exercising of ISOs.  That is, if I exercise options, even if they’re worth a lot of money according to the FMV, I will not pay normal tax.  However, I may need to pay AMT.  AMT is a function of a lot of things (again, it’s insanely confusing), but for this discussion it’s mostly a function of the difference between strike price and FMV.  That is, if you exercise options for $.10 a share and those shares have a $5.00 FMV, it’s likely you will be required to pay AMT depending on the amount of options exercised, your household income, and other factors.  For example, let’s say I exercise 10,000 options at a strike price of $.10 and a FMV of $5.00.  This means I will pay $1,000 to my employer for a quantity of stock worth $50,000.  This difference of $49,000 could force me to be eligible for AMT, depending on my household income and other factors.  What’s so problematic about AMT is that you may need to pay taxes on exercised options without being able to sell your shares, perhaps because your company doesn’t yet allow selling of shares.  So imagine the following example:

  1. Exercise 10,000 options at a strike price of $.10
  2. Pay my employer $1,000
  3. Assume FMV of $5.00 per share, making my options worth $50,000
  4. Assume AMT applies to me
  5. I may need to pay thousands or tens-of-thousands of dollars in AMT taxes due to the $49,000 difference, depending on household income and other factors
  6. The company goes bankrupt and my shares are worth nothing.

The above situation is possible because the FMV is very volatile in startups.  Let’s say the FMV drops from $5.00 to $1.00 the next tax year, I’ve still paid taxes on a $5.00 FMV!  And if the company goes bankrupt I’ll have paid taxes on equity I wasn’t able to sell!  And I’ll have given the company money to exercise my options!  Ouch!  Note that in this case one accumulates AMT credit, which might decrease future AMT amounts.  Again, wildly complicated!

One only needs to optimize for AMT in the event of an increase in FMV.  If your startup sees a large increase in FMV, you should absolutely attempt to exercise your options before the FMV increases, avoiding AMT altogether.  Otherwise you’ll need to be prepared to pay taxes in April, or make the decision to wait to exercise and immediately sell, forcing you to pay short-term capital gains.

Conclusions

ISOs and their tax implications are confusing and tricky.  And playing this game may save you thousands, hundreds of thousands, or even millions of dollars depending on how your startup performs.  I highly recommend reading Consider Your Options and consulting a tax specialist if you get yourself some stock options.  And please let me know if my post is incorrect, or if I’m missing anything.

In other news, I was expecting this post to be nice and short, in contrast to most other essays on this subject.  However, I seem to have failed to make this short and concise.  Pesky task law :).

  • Ian Wrigley

    Good stuff — thanks, Alex!

  • http://cloudera.com Jeff

    Glad that book proved useful.

  • Guest

    Hey Alex, I know this post is old, but I had a quick question; is the AMT that you’re discussing paid based on the FMV when you exercise, or the FMV when you pay your taxes?

  • http://alexlod.com Alex Loddengaard

    Good question.  The AMT is paid based on the FMV when you exercise, not when you pay your taxes.

  • Mule65

    How do short-term capital gains result from exercising?  Either they qualify as long-term capital gains or disqualify as ordinary income.

  • http://alexlod.com Alex Loddengaard

    I may have my points mixed up here a little.  I thought an exercise was always short-term capital gains.  Although maybe they only apply as long-term capital gains if you hold the option for at least a year?

  • Mule65

    Because of the AMT, holding a lot of shares for long-term capital gains is too risky for most people.  I’m pretty sure any disqualifying disposition will result in ordinary income on your W2.  One big difference is you can’t offset significant ordinary income with carryover capital losses from past years.

  • http://alexlod.com Alex Loddengaard

    Thanks!