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Purchase Stock Using an IRA

Holding Private Shares in an IRA

It is very common for founders or early employees to have an opportunity to buy a substantial amount of stock in a promising startup company at a very low price. If your company permits transfers to your own IRA, you can create an IRA account at a special financial institution such as Pensco and then move your private shares into it. However, you are limited to how much, if any, you can contribute to an IRA each ye

Qualified Small Business Stock

A potentially huge tax savings available to founders and early employees is being able to exempt up to $10 million in capital gains or 10x the invested capital, whichever is greater, from federal taxes if the investment was held at least 5 years. Exercising stock options from an eligible company counts as investing! The rules applying to Qualified Small Business Stock (QSBS) were designed to encourage investments in certain small businesses.The exemption no longe

Exercise Just Enough Options Each Year To Avoid AMT

Qualified Incentive Stock Options (ISOs) are not subject to ordinary income tax when exercised but are subject to Alternative Minimum Tax. Most people are not subject to AMT, so you can use our AMT calculator method to determine just how many shares you can exercise each year before tripping the AMT threshold. The basic idea is to set up your tax program to calculate your likely taxes for this year except indicate that you only exercised one share.

So You Want To Save On Taxes When Exercising Options

Venture-backed startup companies are big fans of using incentive stock options to attract and retain employees. A company can issue large incentive stock option grants to its employees with no tax impact on the employee on the date of issue provided the exercise price (also called strike price) is equal to or exceeds the fair market value of the stock on the date of grant. Many times, employees wait to exercise their stock options until a sale Venture-backed startup companies are big fans of using incentive stock options to attract and retain employees. is within sight. Then they exercise and sell the stock. Their reasoning is that they don't want to invest their hard earned cash in a stock that may, like many venture investments, become worthless. While this last minute exercise may seem rational by conserving cash and avoiding loss, in many cases it is not. Why? Because the option holders have failed to consider the taxes they will have to pay and the huge difference between ordinary federal income tax rates (in 2018 a maximum rate of 37%) and federal long term capital gains rates (in 2018 rates  ranging from 15% to 20%). The medicare taxes of 3.8% are generally added to ordinary income tax but not capital gains income until a threshold is surpassed. And there can be additional state tax savings depending on where the employee lives.

So, an option holder who exercises at the time of a company liquidity event and immediately sells his stock pays up to 37% in federal income tax on the gain between the exercise price and the sales price of the stock. In contrast, had the same option holder exercised a year earlier (to comply with the long term capital gains rule that shares must be held for 1 year from the date of exercise and 2 years from the date of grant), the federal income tax could have been at the lower capital gains rate. Another benefit to exercising private company incentive stock options early comes from minimizing Alternative Minimum Tax (AMT) associated with exercising incentive stock options after the fair market value has risen significantly higher than the original strike price on the grant. But if not thoughtfully considered as a part of overall strategy, early exercise to avoid the AMT can backfire. For example, during the late 1990's dotcom bubble, many employees exercised early in an effort to qualify for long term capital gains only to have the stock value collapse during the one year holding period. These optionees were left with a huge AMT bill with the IRS but with no money to pay it. Had they exercised even earlier, when the spread between the strike price and fair market value was less or nonexistent, they could have spared themselves this issue. Click here for more ways to save on taxes associated with stock options.

There can be clear advantages with early exercise of incentive stock options and sometimes the earlier the better. But the risk and cost associated with exercising stock options can be burdensome for many individuals. Where to get the funds? How much risk to take? Look here for a summary of other ways to save money on stock option taxes. The ESO Fund can help alleviate these risks by providing the funds to exercise stock options and to pay applicable taxes such as AMT. No payments are due unless and until there is a liquidity event involving the company that issued the shares, such as a sale or IPO. At that time, the owner of the stock and ESO share the upside of the liquidity event and ESO is repaid.

For more information regarding how working with ESO can benefit you, please contact us at the ESO Fund.

 

Dividing Stock Options In a Divorce

Stock options in high-potential private companies can represent a significant source of wealth on a family's balance sheet. However, in a divorce proceeding, stock options, like other marital property, must be valued and divided between the parties.

But how do you determine the value of stock options?The decision to exercise stock options implicates yet another thorny issue: which party supplies the cash to exercise the options? One party will

High Growth a Double Edged Sword

Regardless of risk appetite, startup employees should understand how changes in the company valuation affects them.Cybersecurity startup Cylance is experiencing tremendous growth, but this growth might burn employees with cheap stock options. Many employees assume as the company grows, they will make a ton of money on exit; however, the timing of their exercises can change the outcome significantly. The main contributing factors are the different tax rates employees are subject to over time.As demonstrated below, Cylance has been growing at about 10% a month while experiencing non-existent churn. Few startups can boast such a growth rate. However, high growth may come at a price to employees with stock options.

Cylance Growth and Churn

As a company scales and grows, the valuation of the company grows just as quickly. As the valuation rises, the potential AMT tax bill for an employee with stock options rise as well. Uber – the famous ridesharing company – 40xed in a single year! Many early employees saw their tax bill 40x as well. What may have been a small $10,000 tax bill transformed into $400,000 in less than a year.

Cylance's growth rates are reminiscent of a rocketship. Cylance's valuation has already hit $1B and has the potential to continue to rise. Employees at the company would benefit from exercising earlier in order to protect themselves from a ever-increasing and compounding tax bill.

Employees at other rocketship companies such as Stripe and Slack face similar issues. Employees at earlier stage rocketships such as Pindrop Security, Collective Health, or NerdWallet stand to benefit the most from exercising early.

Strategies for varying risk appetite

RiskExerciseTax Rate
LowNet-exercise At exitOrdinary Income Tax
MediumExercise as you vestShort Term or Long Term Capital Gains with potential AMT
HighEarly exercise (might not be allowed)Short Term or Long Term Capital Gains without AMT

Low Risk: Employees that play it safe tend to stay at a company until exit. The employee would net-exercise when the company is bought or goes public. They would earn a large payout, but they will be taxed at the Ordinary Income Tax Rate which worst-case can be as high as 52.90% (up to 39.60% Federal + 13.30% for California). If an employee wants to leave or move on, they may find themselves with a massive tax bill or losing all of their options.

Medium Risk: For employees confident in their company, a good strategy would be to exercise as you vest. This strategy requires risking money by buying shares in the company. As a result, if the company fails, the employees may lose their entire investment including any taxes they paid. If the company succeeds, employees who exercised their shares a year before the exit will be subject to the Long Term Capital Gains Tax Rate which worst-case can be as high as 37.10% (up to 23.80% Federal + 13.30% for California). The difference between Ordinary Income Tax and Capital Gains Tax could result in up to 20% of savings. A caveat however, is if the difference between the strike price and the fair market value of the company is already massive at the time of exercise, the employee may be subject to a large AMT tax bill (up to 35%, 28% Federal + 7% for California).

High Risk: If offered the opportunity to early exercise, the savings can be the greatest; however, the risk is also the highest. Employees who exercise all of their options stand to lose everything they invested if the company fails. If the company succeeds, the employees will almost always be subject to the Long Term Capital Gains Tax Rate (if the company exits a year or more after exercising). This is most advantageous if the strike price is equal to the fair market value (409A value) at the time of exercise.

Regardless of risk appetite, startup employees should understand how changes in the company valuation affects them. In high growth situations, understanding the nuances of the different tax rates can help employees optimize their own financial gains and interests. A viable option for many employees is to let the Employee Stock Option Fund to invest on their behalf, which can result in a good balance between eliminating risk and optimizing tax benefits.

Conserve Your Cash

For people who work in private, venture-backed companies, stock options may represent the most potentially valuable asset they have. Note that key word–potentially. Stock options aren't a sure thing. For every private company that goes public or is sold for high price, many more are liquidated and the people who own common stock or exercised their options lose 100% of their investment.

When people change jobs, they usually have 90 days to decide if t