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

 

September 15th, 2014

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