8 ms·

Generally this occurs when you exercise an option to purchase stock, then hold the stock while it significantly depreciates in value. Fairly common scenario dur

Generally this occurs when you exercise an option to purchase stock, then hold the stock while it significantly depreciates in value. Fairly common scenario during the dot-com bubble. 1) Option at $1 2) Exercise at $100, spending $1 to buy. Tax on $99 short term capital gains owed, or ~$35. 3) Stock falls to $10 and sold for a $9 profit. You still owe $35 capital gains and spent $1. Net loss of $25 per share.

ajmurmann 10y ago
Did you mean "2) Exercise at $100 [..]"?
tuna-piano 10y ago
Wouldn't the prudent thing to do be to sell at least enough stock to pay the tax? If not allowed to sell at that point- just short stock to have the equivalent effect (minus fees)? Something else I've never understood to be rational - If you wouldn't buy $10 in yahoo stock- why would you hold it because you have it? My uninformed but seems logical answer would be sell the stock you got, pay the tax and buy and index fund.
- stepanhruda 10y ago
  The stock needs to be public by the time you exercise to be able to do this.
  - trimbo 10y ago
    When Yahoo bought Geocities, both were public.
- xxbondsxx 10y ago
  > Wouldn't the prudent thing to do be to sell at least enough stock to pay the tax? It's not liquid yet, that's the issue. That's what is nice about most RSU plans -- they immediately sell to cover, so you don't receive a ton of stock with an attached tax bill. But illiquid options are different; the capital gains tax is for the paper-wealth you just received. That same paper wealth can evaporate, but the tax bill remains.
  - tuna-piano 10y ago
    So you have an asset that is considered worth a price, but you cannot buy it or sell it at that price? Seems to me an unfortunate tax policy.
    - demonshalo 10y ago
      almost all tax policies are unfortunate.
      - lostlogin 10y ago
        .. Although it is handy to have had an education, healthcare, police service, fire service, roads, libraries etc. But other than that stuff, it's very unfortunate.
        gvb 10y ago
        The OP said due to tax policy, not taxes. Due to perverse incentives (pandering to various classes of voters) and unintended consequences, tax policies have become byzantine horrors.
        Bartweiss 10y ago
        Very broadly, it seems like tax policy fails to cope (pleasantly) with anything other than totally standard earnings. If you earn a steady wage, or simple capital gains, things go fine. Anyone dealing in options, variable hours, contract work, or anything else unconventional faces totally irrational outcomes unless they're exceedingly careful.
        Bartweiss 10y ago
        That's about taxation, not tax policy. How much money you need to collect and how you collect it are two very different beasts. Virtually any unconventional earnings have the potential to screw you based on the intricacies of law, rather than the average tax rate employed.
    - 10y ago
- ng12 10y ago
  The prudent thing is to only do cash-positive transactions, but that's easier said than done when the majority of your net worth is tied to your company. Good Technologies is a good example -- any employee who purchased NSOs while they were still private got shafted: http://www.businessinsider.com/long-weird-history-of-good-technology-2015-12 http://www.businessinsider.com/long-weird-history-of-good-te...
- ghaff 10y ago
  You're right but remember that this was happening during a period when it was really hard to not get sucked into the "irrational exuberance" with Yahoo being as much of a poster child as anyone. I got burned in this way with my company's options but fortunately only a modest amount that I exercised and held. I had a fair number of total shared but fortunately they recovered somewhat over time and have been a good source of capital gains offsets in any case :-)
theli0nheart 10y ago
> 2) Exercise at $100 [1], spending $1 to buy. Tax on $99 short term capital gains owed, or ~$35. This makes no sense. Simply exercising an option is not a taxable event--you're just trading a contract for shares of a stock. There's no money going into your bank account. Furthermore, you aren't taxed short-term capital gains when you haven't realized a profit. You'd need to exercise AND sell at $100 / share for those gains to be taxable. The correct taxable amount in this scenario would be $9 / share ($1 spent, $10 earned, net gains = $9). [1] Assuming you meant "exercise at $100" here.
- powera 10y ago
  Excercising an option is taxable under the AMT.
- bhickey 10y ago
  It may make no sense, but the IRS disagrees with you. Exercising is a taxable event.
  - theli0nheart 10y ago
    That's only for ISOs, which are essentially deferred compensation. Getting paid in ISOs is functionally equivalent to taking an 83(b) election in that you're trading a risk of potential loss for the upside of only needing to pay long term capital gains tax.
    - twblalock 10y ago
      You are confused. Exercise of incentive stock options (ISOs) is not a taxable event, although you may get hit with the AMT. Exercise of non-qualified options (NSOs) is a taxable event. For both types of options, the sale of the stocks at a later time is taxable.
      - limeyx 10y ago
        ^ - this.
bsbechtel 10y ago
So if you exercise an option to buy a stock for $1, you have to pay taxes on the stock's current value, but if you had bought the stock outright at $1, you don't have to pay capital gains until you sell? That's absurd
- skewart 10y ago
  Yes. Yes it is absurd. A lot of people have been screwed over by this situation. I think it's basically a bug in US tax law. The scenario is such an edge case for most Americans. The other not-so-nice aspect of this is that it disproportionately affects people who aren't already relatively wealthy. Theoretically you can avoid this trap by exercising your options as soon as possible and locking yourself into long-term capital gains. But if you're joining a relatively established startup it may well be pretty expensive to immediately exercise your options. If you don't have, say, 100k lying around you have to wait until there's liquidity, thus opening yourself up to this risk.
- Spoom 10y ago
  There are some downsides but this is one of the reasons that phantom stock and phantom stock options[1] can be good for employees as there is essentially nothing taxable until the actual payout, which is treated as regular income and can have taxes withheld like a normal bonus. 1. https://en.wikipedia.org/wiki/Phantom_stock https://en.wikipedia.org/wiki/Phantom_stock
  - skewart 10y ago
    Phantom stock is super interesting. Do startups ever offer it? I'd be curious to know how it worked out. It seems like it would be better than the worst case with traditional options but not as good as the best case. I mean, ideally you exercise your options early at a very low price and then enjoy long-term capital gains tax rates. Phantom stock means you'll always pay way more in taxes when you get your equity-based payout - 50%-60% vs 20%-30%. At the same time though you are never at risk of ending up underwater. It seems like phantom stock would be great as an option for companies to offer employees - i.e. you could either get a traditional options structure or phantom stock. I wouldn't be surprised if there were negative accounting or tax consequences for the company though. And maybe the administrative overhead for offering phantom stock in addition to traditional options would be prohibitive for small startups.

ajmurmann 10y ago

Did you mean "2) Exercise at $100 [..]"?

tuna-piano 10y ago

Wouldn't the prudent thing to do be to sell at least enough stock to pay the tax? If not allowed to sell at that point- just short stock to have the equivalent effect (minus fees)? Something else I've never understood to be rational - If you wouldn't buy $10 in yahoo stock- why would you hold it because you have it? My uninformed but seems logical answer would be sell the stock you got, pay the tax and buy and index fund.

stepanhruda 10y ago
The stock needs to be public by the time you exercise to be able to do this.
- trimbo 10y ago
  When Yahoo bought Geocities, both were public.
xxbondsxx 10y ago
> Wouldn't the prudent thing to do be to sell at least enough stock to pay the tax? It's not liquid yet, that's the issue. That's what is nice about most RSU plans -- they immediately sell to cover, so you don't receive a ton of stock with an attached tax bill. But illiquid options are different; the capital gains tax is for the paper-wealth you just received. That same paper wealth can evaporate, but the tax bill remains.
- tuna-piano 10y ago
  So you have an asset that is considered worth a price, but you cannot buy it or sell it at that price? Seems to me an unfortunate tax policy.
  - demonshalo 10y ago
    almost all tax policies are unfortunate.
    - lostlogin 10y ago
      .. Although it is handy to have had an education, healthcare, police service, fire service, roads, libraries etc. But other than that stuff, it's very unfortunate.
      - gvb 10y ago
        The OP said due to tax policy, not taxes. Due to perverse incentives (pandering to various classes of voters) and unintended consequences, tax policies have become byzantine horrors.
        Bartweiss 10y ago
        Very broadly, it seems like tax policy fails to cope (pleasantly) with anything other than totally standard earnings. If you earn a steady wage, or simple capital gains, things go fine. Anyone dealing in options, variable hours, contract work, or anything else unconventional faces totally irrational outcomes unless they're exceedingly careful.
      - Bartweiss 10y ago
        That's about taxation, not tax policy. How much money you need to collect and how you collect it are two very different beasts. Virtually any unconventional earnings have the potential to screw you based on the intricacies of law, rather than the average tax rate employed.
  - 10y ago
ng12 10y ago
The prudent thing is to only do cash-positive transactions, but that's easier said than done when the majority of your net worth is tied to your company. Good Technologies is a good example -- any employee who purchased NSOs while they were still private got shafted: http://www.businessinsider.com/long-weird-history-of-good-technology-2015-12 http://www.businessinsider.com/long-weird-history-of-good-te...
ghaff 10y ago
You're right but remember that this was happening during a period when it was really hard to not get sucked into the "irrational exuberance" with Yahoo being as much of a poster child as anyone. I got burned in this way with my company's options but fortunately only a modest amount that I exercised and held. I had a fair number of total shared but fortunately they recovered somewhat over time and have been a good source of capital gains offsets in any case :-)

theli0nheart 10y ago

> 2) Exercise at $100 [1], spending $1 to buy. Tax on $99 short term capital gains owed, or ~$35. This makes no sense. Simply exercising an option is not a taxable event--you're just trading a contract for shares of a stock. There's no money going into your bank account. Furthermore, you aren't taxed short-term capital gains when you haven't realized a profit. You'd need to exercise AND sell at $100 / share for those gains to be taxable. The correct taxable amount in this scenario would be $9 / share ($1 spent, $10 earned, net gains = $9). [1] Assuming you meant "exercise at $100" here.

powera 10y ago
Excercising an option is taxable under the AMT.
bhickey 10y ago
It may make no sense, but the IRS disagrees with you. Exercising is a taxable event.
- theli0nheart 10y ago
  That's only for ISOs, which are essentially deferred compensation. Getting paid in ISOs is functionally equivalent to taking an 83(b) election in that you're trading a risk of potential loss for the upside of only needing to pay long term capital gains tax.
  - twblalock 10y ago
    You are confused. Exercise of incentive stock options (ISOs) is not a taxable event, although you may get hit with the AMT. Exercise of non-qualified options (NSOs) is a taxable event. For both types of options, the sale of the stocks at a later time is taxable.
    - limeyx 10y ago
      ^ - this.

bsbechtel 10y ago

So if you exercise an option to buy a stock for $1, you have to pay taxes on the stock's current value, but if you had bought the stock outright at $1, you don't have to pay capital gains until you sell? That's absurd

skewart 10y ago
Yes. Yes it is absurd. A lot of people have been screwed over by this situation. I think it's basically a bug in US tax law. The scenario is such an edge case for most Americans. The other not-so-nice aspect of this is that it disproportionately affects people who aren't already relatively wealthy. Theoretically you can avoid this trap by exercising your options as soon as possible and locking yourself into long-term capital gains. But if you're joining a relatively established startup it may well be pretty expensive to immediately exercise your options. If you don't have, say, 100k lying around you have to wait until there's liquidity, thus opening yourself up to this risk.
Spoom 10y ago
There are some downsides but this is one of the reasons that phantom stock and phantom stock options[1] can be good for employees as there is essentially nothing taxable until the actual payout, which is treated as regular income and can have taxes withheld like a normal bonus. 1. https://en.wikipedia.org/wiki/Phantom_stock https://en.wikipedia.org/wiki/Phantom_stock
- skewart 10y ago
  Phantom stock is super interesting. Do startups ever offer it? I'd be curious to know how it worked out. It seems like it would be better than the worst case with traditional options but not as good as the best case. I mean, ideally you exercise your options early at a very low price and then enjoy long-term capital gains tax rates. Phantom stock means you'll always pay way more in taxes when you get your equity-based payout - 50%-60% vs 20%-30%. At the same time though you are never at risk of ending up underwater. It seems like phantom stock would be great as an option for companies to offer employees - i.e. you could either get a traditional options structure or phantom stock. I wouldn't be surprised if there were negative accounting or tax consequences for the company though. And maybe the administrative overhead for offering phantom stock in addition to traditional options would be prohibitive for small startups.