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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 year. The Fair Market Value (FMV) of your shares at the time of the transfer will count against that annual limit. As such, it is best to do this when your company is young and the stock has a very low value. Once you achieve this, all future gains on the shares will be tax deferred. This is especially valuable in a hot IPO market when your shares have run up in value. In this situation, it is common for employees to net exercise their options or sell their shares in order to capture value before a possible stock collapse. But by doing so, they trigger a lot of taxes on the profits in addition to raising their tax brackets on all sources of income including their base income. On the other hand, shares held in an IRA won't cause either problem and will benefit from compounding effects over the years since all profits can be reinvested instead of being used for taxes.

Purchasing Private Shares with an IRA

If your Pensco IRA is sufficiently funded from prior gains or contributions, you can purchase private shares from these funds as well. By doing so, all gains on this investment will accrue tax-deferredBy doing so, all gains on this investment will accrue tax-deferred until you withdraw the money at age 59 1/2 or higher. Even if you need to withdraw the money sooner to cover an emergency, the 10% penalty and taxes might still be worth it considering how much was saved over the years. However, it is unlikely that you can exercise employee stock options directly from an IRA because of IRS rules relating to options granted in connection with employment. Options and warrants granted in non-employment situations such as investing are usually eligible though.

Roth IRA

Normally, highly compensated employees at fast growing technology companies are not eligible to make Roth IRA contributions. However, the IRS frequently allows IRA conversions as a mechanism to generate near term tax revenue for the government. During such a window, you can convert your IRA into a Roth IRA by paying the taxes on the amount converted as if it was an authorized distribution. Although the taxes paid effectively increases the amount that you have invested in your stock, your return on investment can be enormous since the final proceeds will be tax free for the most part as opposed to merely tax deferred in the case of regular IRAs. Note that the amount of taxes you pay on your Roth conversion will be a function of the FMV of your stock at the time of conversion as opposed to the time of contribution, so it is best that you do it early on while the valuation is still low. Although Qualified Small Business Stock(QSBS) exemptions can be less expensive to execute, the tax savings is limited to federal tax for many states, the investment must be held at least 5 years, and the exemption on capital gains is capped at the higher of $10 million or 10x the invested capital. Although an investment using a Roth IRA doesn't have those QSBS limitations, it is subject to many other restrictions. Be aware that the rules governing IRA's outline a number of prohibited transactions including self dealing in situations where you control the asset in which you invested. That can be risky for founders who own a large percentage of their companies. Since this is a grey area of the law, it is highly recommended that you seek professional advice before doing this.

If you hold employee stock options or restricted shares in a private company funded by institutional venture capital, feel free to contact us at the Employee Stock Option Fund for more information on how we can assist you. By doing so, you can not only avoid the risks associated with investing directly in a startup but possibly improve your taxes as well. For specific tax related support regarding stock option exercises, please contact Scott Chou.

© 2012-2019 Employee Stock Option Fund. All Rights Reserved. The ESO Fund does not provide legal, financial, or tax advice.

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. The rules applying to Qualified Small Business Stock (QSBS) were designed to encourage investments in certain small businesses.The exemption no longer applies to California income taxes since 2012 However, the exemption no longer applies to California income taxes since 2012. Some entrepreneurs contemplate leaving California before their M&A or IPOs are completed, but be warned that this must be a bonafide intention to move and is subject to audit for at least 3 years. Other states should be reviewed on a case by case basis.

The main factors to qualify for QSBS status are:

  • The stock has to be purchased directly from the company as opposed to a secondary market.
  • The company needs to be a C corporation.
  • The stock had to be issued after August 10, 1993.
  • Company issuing the stock has had less than $50 million in total assets continuously from inception or August 10, 1993 through the point where the investment was made.
  • Certain redemptions can retroactively eliminate QSBS status.
  • Many service businesses, hotels, banks, insurance companies, farms, etc. are not eligible for QSBS treatment.
  • If you have not yet met the 5 year threshold, you can do a qualified rollover into another QSBS until the 5 years has been achieved.

For professional tax assistance on your QSBS situation, feel free to contact Leung, Louie, IP & Co. LLP.

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. You'll You also have the benefit of avoiding larger amounts of AMT that would otherwise be dueneed to know the current Fair Market Value (FMV) of your shares in order for the software to calculate your tax impact. Then go back and change that 1 share to 2 shares and see if your tax increases. If not, then you aren't subject to AMT at all. If it goes up right away, then you are subject to AMT based on your base income regardless of how many shares you exercise. But if not, then gradually increase the number of shares you exercise until your taxes due/refund finally changes. That will be the threshold where you first trip AMT, so you can exercise up to that many of your ISO shares without tax consequences and thereby get a head start on your eligibility for long term capital gains treatment. You also have the benefit of avoiding larger amounts of AMT that would otherwise be due if you were to exercise these shares later on when the current FMV of your shares is higher.

If you can't afford the cost or bear the risk of exercising your shares, you can contact us at the Employee Stock Option Fund for a non-recourse cash advance against those shares. If those shares turn out to not be a good investment, ESO bears the loss as opposed to you. Visit this page for more ideas on how to save money on stock option taxes.

© 2012-2018 Employee Stock Option Fund. All Rights Reserved. The ESO Fund does not provide legal, financial, or tax advice.

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 almost certainly consider the options risky and low-valued whereas the other party will try to characterize the company as the next Google. Lawyers may use Black Scholes and other methods to try to arrive at a value, but this doesn't solve the basic problem that in fact no one knows whether the stock in the company will have any value at all since many private companies fail.

Who bears the risk of that potential failure? The solution is to  exercise the options and then the resulting shares of stock can be divided and transferred as a tangible asset. Although most private companies have transfer restrictions on their private stock, transfers between immediate family members are usually exempted. Or if the options can be transferred between the parties (such as non-qualified options NSOs), the options can be transferred and then exercised. The decision to exercise stock options implicates yet another thorny issue: which party supplies the cash to exercise the options? The underlying stock typically cannot be sold and though the company may have high potential, it also carries a high risk of failure. Neither party in the divorce may want to bear that risk or be financially able to do so. And if taxes are due as a result of the exercise, how are those to be paid?

The solution is to have the Employee Stock Option Fund provide the funds needed to exercise the options. Each party in the divorce can then safely presume that they were treated equally with respect to the disposition of the stock option assets. Under the ESO Program, 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 owners of the stock and ESO share the upside of the liquidity event and ESO is repaid. ESO can also finance the potential tax liabilities associated with the stock, such as Alternative Minimum Tax (AMT).

If you'd like to know more about how ESO can help in your particular financial situation, please contact us at the ESO Fund.

 

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 they want to exercise their incentive stock options. For years, there were really only 2 choices: exercise and take the risk of losing your investment or not exercise and lose the options and the possible profits. Now there is a choice that allows you to obtain upside with minimal risk and conserve your cash—obtain an advance from the ESO Fund and use that money to exercise your options. 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, ESO receives an agreed upon payment which will never exceed the value of your stock. As such, ESO is absorbing your financial risk in case the value of the stock collapses.

ESO can also advance funds for potential tax liabilities associated with the stock, such as Alternative Minimum Tax (AMT) or the withholding tax associated with NSOs. Even if you can afford to exercise your options and pay your taxes, by leveraging ESO's funding you can diversify your risk by investing in other assets instead. The combination of equity in your startup company purchased with ESO's help and the assets you invest in directly can represent a safer and larger portfolio than if you merely invested in a single company. An advance from ESO to exercise your options can provide you with significant upside with minimal risk.

If you'd like to know more about how ESO can help your financial situation, please contact us at the ESO Fund.

Tax Consequences When Exercising Stock Options

the addition of taxes makes the entire investment more burdensome as well as risky
The Alternative Minimum Tax (AMT) can apply to current and former employees of privately held companies when they exercise their incentive stock options (ISOs) if the fair market value is higher than the exercise price. The AMT can have a significant cash impact on those who exercise their ISOs. See this page for more information on how to calculate AMT.

Holders of non-qualified stock options (NSOs) are subject to tax at exercise if the fair market value of the stock is higher than the exercise price ("spread"). If you leave a company and negotiate an extension on your exercise period that is longer than 90 days after your final day of employment, then your ISOs will become non-qualified stock options. NSOs stock options are more typically associated with non-employees such as contractors and outside business partners. Moreover, employers are required to withhold at least 25% of the spread at the time of the exercise. This withholding includes federal, medicare, FICA, and applicable state income taxes. Since the cost of exercising stock options could already be very high, the addition of taxes makes the entire investment more burdensome as well as risky.

A solution for reducing this is risk is obtaining an advance from the Employee Stock Option Fund to cover the entire cost of exercising your stock options, including the tax. An indirect benefit of letting ESO finance your NSO option exercise is reducing the AMT on your ISOs in case you prefer to only exercise your less expensive options on your own. Similarly, letting ESO finance your ISOs can get you a disqualifying disposition that can eliminate much if not all of the AMT and defer your overall tax liability. Conceptually, ESO is buying your stock after you exercise but paying you in installments. The initial installment just covers your cost of exercising and taxes and the final installment will be at final liquidity and based on the valuation at that time. Since the final installment has an open ended value, it is as if you now have new stock options with unlimited upside potential, no expiration date, and little or no tax liability to achieve this. In summary, an ESO transaction will reduce your tax burden by deferring most of it until final liquidity, eliminating your risk by covering your exercise and taxes, and still leaving future upside on the table. It's like having your cake and eating it too! The main catch is that your ESO transaction must occur during the same tax year in order to qualify for an AMT disqualifying disposition. Click here for a summary of other methods for reducing taxes associated with exercising options.

No payments are due on an ESO cash advance 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 ESO can benefit you, please contact the ESO Fund


AMT Tax Credits

 

Even if you don't elect to take a disqualifying disposition but choose to pay the full AMT, a small potential benefit of having ESO provide your AMT is having AMT credits for subsequent years when you are not subject to AMT. This is a very common result because many people only trigger AMT during the year in which they exercise a large block of stock options. No payments are due under ESO's program 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 ESO can benefit you, please contact the ESO Fund

 

Maximizing The Value Of Your Common Stock Holdings

selling early is not the only alternativeEmployees of venture-backed startups are tied to the illiquidity of their stock positions. As timelines to exit have consistently lengthened, employees have begun looking for liquidity alternatives such as secondary market sales to enable them to cash out early without having to wait for an IPO or M&A exit. However, selling early is not the only alternative, and it may not be the best way to maximize the value of your equity holdings. While selling early provides near-term cash, it forever limits your future upside potential because once the stock is sold, there is no additional upside to be gained by the seller. It also requires dealing with transfer restrictions that companies place on such transactions. While companies can waive transfer restrictions, the point is that they must be dealt with somehow in a typical sale.

In contrast, a transaction with the Employee Stock Option Fund can be structured to not trigger company transfer restrictions and also let you retain equity upside should the company have a positive liquidity event. The ESO Fund provides financing for option exercises and for liquidity based on issued shares. 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. ESO's program is an attractive alternative to direct stock sales, and can serve to maximize the value of stock ownership in venture-backed startups.

Please contact us if you would like to learn more about how the ESO Fund can help you.

How Recruiters Can Get Help From Eso Fund

stock options can act as golden handcuffs and why so many companies utilize them as a retention toolAs an executive recruiter, you may often encounter a promising candidate who is reluctant to leave his or her current position because of vested stock options — even though the candidate may feel that your client's job may have better potential. This psychological reluctance is the fundamental logic behind how stock options can act as golden handcuffs and why so many companies utilize them as a retention tool.

The Employee Stock Option Fund (ESO Fund) can help in those situations. ESO provides financing to current and former employees of private companies to allow them to exercise their stock options. This innovative service allows executive recruiters and their company clients to "take off the table" any discussion of advancing funds to a new hire to exercise options at the candidate's former company. These valuable funds can be utilized for more important expenses such as relocation. Moreover, these bonus funds are fully taxed which makes them a very expensive way to exercise options which also trigger additional taxes. No payments are due under ESO's program unless and until there is a liquidity event involving the company that issued the shares, such as a sale or IPO. Only at that time does the owner of the stock repay ESO and risk is avoided because the repayment terms will never exceed the value of the stock. For the candidate, an ESO advance allows him or her to take a portfolio approach to private company stock by obtaining stock in their old company (which provides possible opportunities for gain) as well as allowing them to assume a new position in a new company with a new option position.

For more information regarding ESO and how we can help recruiters and their placement candidates, please contact us at the ESO Fund.