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If I understand the rules correctly, an ISO that is exercised more than 90 days after leaving a job is treated as an NSO, which means that it will be taxed at r

by SeoxyS 11y ago

If I understand the rules correctly, an ISO that is exercised more than 90 days after leaving a job is treated as an NSO, which means that it will be taxed at regular income tax rates instead of having the ability to be taxed at long-term cap gains rate. (This could reduce their value by an additional 15%+.) That said, it's irrelevant if you exercise and sell an ISO at the same time, because short-term cap gains are taxed as income tax, too. The real interesting term is having the ability to early exercise your entire stock grant, before it vests and before there is a spread between its strike price and fair market value. (The company would have a repurchase right, to implement the vesting schedule.) That way the cost is very low, and there's no worry of having to exercise in the future when it could be taxed unfavorably, and the clock for long-term capital gains starts early.

epa 11y ago
It should be noted - an option containing an early exercise attribute is typically rare for common option holders and usually only reserved for management. I.e. most people with a typical amount of options (~5,000) would typically not have this ability.
- rdl 11y ago
  Less true now. It's $1-3k/employee for the company to deal with it, but a lot of companies include ee, even up to the point where they switch to RSUs.
bradleyjg 11y ago
If there's a repurchase agreement that allows the company to buy back the stock for less than market value (and presumably accompanying transfer limitations) I wonder if the IRS would take the position that it is income only after the repurchase agreement expires at the FMV at that point in time.
- trjordan 11y ago
  The way it works for founders is that you get actual stock, and vesting is implemented with a repurchase right. The IRS considers the stock to be an "asset at risk", meaning that you don't actually realize the value as income until the repurchase right goes away. Because this happens over time, it practically means founder stock is, by default, treated as being earned every month. This is no big deal in the beginning, but if you change the valuation of the company, suddenly each monthly stock grant has a discrepancy between what you paid for it and what it's worth. Therefore, it's income, therefore, you owe taxes on it. The way to fix this is an 83(b) election, which lets you say, "No, I'm taking the risk of this all up front. I want to pay taxes on it, even though the asset is at risk." In this specific case, it's a no-brainer: there are no taxes today, so of course I'll pay that $0. If you want to do this with employee options, you have to set up early exercise rights. I think early exercise is done via 83(b) for employees, but I'm not 100% on that. My company isn't big enough that we've had to cross that bridge :)
  - toast0 11y ago
    > If you want to do this with employee options, you have to set up early exercise rights. I think early exercise is done via 83(b) for employees, but I'm not 100% on that. Yes, if you early exercise ISOs, you would want to file an 83(b) to pay the $0 ordinary income tax burden up front (and get long term capital gains later). I'm not sure if you can file an 83(b) on an NSO.
    - GauntletWizard 11y ago
      It sounds like an incredibly complicated process to get to "These options are no longer options, they are stock with basis zero"; Am I correct?
      - toast0 11y ago
        It's a little complicated, but it can be very helpful. The basis isn't zero either, it's what you paid to exercise the option. The tax due at time of exercise is $0 because the fair market value is the same as what you paid (assuming you exercise either at the time of the grant, or at least before the next evaluation of the FMV). The benefit is if/when you sell, if you've held everything for the right period, you can pay long term capital gains tax on the gain, instead of ordinary income like you would if you held onto the option as an option.
Teodolfo 11y ago
Many people would prefer the NSO since they don't lose out on vested shares upon departure (or get saddled with a massive tax bill). If you have a good chunk of equity, the outcome can be pretty binary: worth something substantial or basically nothing, in which case the slightly higher tax isn't nearly as important as actually getting a piece.

by SeoxyS 11y ago

epa 11y ago

It should be noted - an option containing an early exercise attribute is typically rare for common option holders and usually only reserved for management. I.e. most people with a typical amount of options (~5,000) would typically not have this ability.

rdl 11y ago
Less true now. It's $1-3k/employee for the company to deal with it, but a lot of companies include ee, even up to the point where they switch to RSUs.

bradleyjg 11y ago

If there's a repurchase agreement that allows the company to buy back the stock for less than market value (and presumably accompanying transfer limitations) I wonder if the IRS would take the position that it is income only after the repurchase agreement expires at the FMV at that point in time.

trjordan 11y ago
The way it works for founders is that you get actual stock, and vesting is implemented with a repurchase right. The IRS considers the stock to be an "asset at risk", meaning that you don't actually realize the value as income until the repurchase right goes away. Because this happens over time, it practically means founder stock is, by default, treated as being earned every month. This is no big deal in the beginning, but if you change the valuation of the company, suddenly each monthly stock grant has a discrepancy between what you paid for it and what it's worth. Therefore, it's income, therefore, you owe taxes on it. The way to fix this is an 83(b) election, which lets you say, "No, I'm taking the risk of this all up front. I want to pay taxes on it, even though the asset is at risk." In this specific case, it's a no-brainer: there are no taxes today, so of course I'll pay that $0. If you want to do this with employee options, you have to set up early exercise rights. I think early exercise is done via 83(b) for employees, but I'm not 100% on that. My company isn't big enough that we've had to cross that bridge :)
- toast0 11y ago
  > If you want to do this with employee options, you have to set up early exercise rights. I think early exercise is done via 83(b) for employees, but I'm not 100% on that. Yes, if you early exercise ISOs, you would want to file an 83(b) to pay the $0 ordinary income tax burden up front (and get long term capital gains later). I'm not sure if you can file an 83(b) on an NSO.
  - GauntletWizard 11y ago
    It sounds like an incredibly complicated process to get to "These options are no longer options, they are stock with basis zero"; Am I correct?
    - toast0 11y ago
      It's a little complicated, but it can be very helpful. The basis isn't zero either, it's what you paid to exercise the option. The tax due at time of exercise is $0 because the fair market value is the same as what you paid (assuming you exercise either at the time of the grant, or at least before the next evaluation of the FMV). The benefit is if/when you sell, if you've held everything for the right period, you can pay long term capital gains tax on the gain, instead of ordinary income like you would if you held onto the option as an option.

Teodolfo 11y ago

Many people would prefer the NSO since they don't lose out on vested shares upon departure (or get saddled with a massive tax bill). If you have a good chunk of equity, the outcome can be pretty binary: worth something substantial or basically nothing, in which case the slightly higher tax isn't nearly as important as actually getting a piece.