Exercising Employee Stock Options 101 (Part 3)


The following post covers the Exercising Stock Options and Taxes from Carta’s presentation “Equity 101 for Startup Employees.” The remaining sections are covered in the rest of this 3-part blog post. You can follow us on Twitter (@cartainc) for updates on upcoming events.

img2

Part 3: Exercising Stock Options and Taxes

We have covered Stock Option Basics and Stock Option Economics for startup employees to help them understand their equity. Now, let’s explore what it means to exercise stock options and the tax treatment you will need to consider if you decide to exercise your options.


We’ll cover four topics in this post:

  1. Two types of taxes to keep in mind when exercising your options
  2. ISO tax treatment and benefits
  3. ISO holding periods required to receive those ISO tax benefits
  4. Common times people exercise stock options

There are two types of taxes treatments you will need to keep in mind when exercising options:

Ordinary Income vs. Capital Gains

Ordinary Income tax applies to things like wages and salaries. Capital Gains tax applies to any profits you make from selling an asset.

To see how both of these taxes come into play with exercising stock options, we’ll be using the stock option payout graph below. This graph shows Kerri’s (our example employee) option payout as a function of Meetly’s (our example company) stock price. The option payout is represented by the yellow line.

img4

Kerri’s option payout is zero at any point when the stock price is below $1. That’s because, at her option strike price of $1, she would need to pay $1 to get $1 in return. As the stock price grows higher than $1, Kerri’s option payout increases.

If Kerri decides to exercise when the stock price is $5, her option payout is $4. That’s the $5 stock price minus her $1 strike price:

img5

Now let’s assume Kerri sells the stock when the stock price is $10. Her option payout here is $9, which is the $10 stock price minus her $1 strike price:

img6

Any gain before the exercise is treated as Ordinary Income tax (see graph below). One way to think about why this is the case is that Meetly let Kerri buy the stock for $1 when it was worth $5. This is almost the same as if they paid her that $4 difference, along with her income and salary.

img7

Any gain in the stock price after the exercise is treated as Capital Gains tax (see below). Because Kerri owns the stock at this point, any gain she makes at sale is a profit from selling the asset.

img8

The main takeaway here is that Ordinary Income tax is almost double the Capital Gains tax rate, so it is favorable to maximize your Capital Gains tax. The smaller the gap between the yellow line and the red line, the better.

Knowing the benefits of Capital Gains tax in comparison to Ordinary Income tax, we can understand the tax benefits of having ISO options (as opposed to NSO options).

ISO and NSO Tax Treatment

The tax benefit of having ISOs is that you do not pay tax on the day you exercise. This contradicts the graph we just saw above, which actually shows the NSO tax treatment.

To visualize this, let’s return to the graph for an NSO exercise. With ISOs, the red line (Ordinary Income tax) goes away. That means you don’t have to pay tax until the day you sell the stock.

img11

In Kerri’s case as an ISO holder(above), the entire $9 payout is taxed as Capital Gains and she does not have to pay that tax until she sells the stock.

Alternative Minimum Tax (AMT) Explained

That said, there is one other type of tax you need to consider when exercising an ISO option: the Alternative Minimum Tax (AMT). AMT is a separate set of tax rules that include external factors like ISO exercises in your tax calculation. If the AMT calculation exceeds the normal amount, you will need to pay the greater of the two calculations. The AMT can potentially reach thousands of dollars depending on your income and the gain you realize from the exercise.


Holding periods

The main tax benefit of having ISO options is startup employees do not have to pay tax on the day they exercise their equity (unless you owe AMT). In order to receive that benefit, however, you need to meet certain holding periods.

The holding period requirement states: the day you sell the stock needs to be at least 2 years after the day your options were granted, and 1 year after the day your options were exercised.

Let’s see what that looks like on our option payout graph:

img15

If either of these holdings periods is not met, your options are treated as NSOs. That means the red line comes back into play and you will need to pay ordinary income tax. You still maintain the ISO tax treatment, however, of not paying this tax until the day you sell the stock.


Times to exercise

To finish, we’ll cover common times startup employees decide to exercise their options.

One of the most common times is upon termination. As discussed in Part 1, most companies require you to exercise your vested stock options within a set window of time after leaving the company. This window is usually 30 to 90 days.

img17

When this happens, you are exercising at some point in the middle of the grant’s life. That means you will most likely pay some mix of Ordinary Income tax and Capital Gains tax upon exercising your stock options.

Another common type of exercise is what’s known as an “early exercise.” Some companies allow this, and it just means you can exercise your options before they have vested.

img18

As you can see in the graph above, the benefit of doing this is that you are minimizing the pre-exercise gain. This could potentially limit your exposure to AMT. The downside here that you are taking on risk. There is no guarantee that your stock will ever be liquid, so you are paying to buy stock that could one day be worthless.

Form 83(b)

If you choose to exercise options early, you will almost always want to file an 83(b) election. You only have 30 days to file this with the IRS, and there are no exceptions. If you fail to file the 83(b) election, you are subject to ordinary income tax every time you vest new shares. (Remember when you exercise options early, your shares are unvested. That means the resulting stock is still subject to vesting.)

The third common time to exercise your stock options is upon an exit. That could be at an IPO or an acquisition.

img20

This is the least risky time to exercise because you know the stock is liquid. You can turn around and sell the stock for a gain (hopefully) the same day you pay to buy it.

The downside in this situation is that you usually end up paying more taxes. Remember those holding periods we discussed above? The day you sell the stock needs to be at least one year after the day you exercised your options. That holding period won’t be met if you sell the stock on the same day you buy it. If this happens, your options will be treated like NSOs, and any pre-exercise gain is taxed as Ordinary Income.


Here’s a quick recap of the post.

  1. The two types of taxation to keep in mind when exercising your options are Ordinary Income tax and Capital Gains tax.
  2. We detailed the ISO tax benefits of having ISO options: you do not pay tax on the day you exercise.
  3. We described the holding periods (2 years from the grant date, 1 year from the exercise date) that need to be met to receive ISO tax benefits.
  4. We finished by explaining the three common times people exercise their options.

Read Equity 101: Part 1

Read Equity 101: Part 2


This presentation about exercising options is meant for educational purposes only. Carta does not provide legal, financial or tax advice of any kind, and nothing in this presentation constitutes such advice. If you have any questions with respect to your own legal, financial or tax matters, please consult a professional adviser.

Related articles


What’s Rule 701 and what’s recently changed?

Learn more about Rule 701, recent updates, and how to stay compliant at your company. Everything from the history of Rule 701 to the most recent changes.

What is a 409A valuation?

Learn everything you need to know about section 409A of the internal revenue code. From what is a 409A valuation to 409A methodologies and process.

Equity 101 – Equity Basics for Founders

Learn the basics of equity, how to distribute equity to early employees, and what a cap table is

eShares, Inc. DBA Carta, Inc. is a transfer agent registered with the U.S. Securities and Exchange Commission. The services and information described in this communication are provided to you “as is” and “as available” without warranties of any kind, expressed, implied or otherwise, including but not limited to all warranties of merchantability, fitness for a particular purpose, or non-infringement. Neither eShares, Inc. DBA Carta, Inc. nor any of its affiliates will be liable for any damages, including without limitation direct, indirect, special, punitive or consequential damages, caused in any way or arising from the use of the services or reliance upon the information provided in this communication or in connection with any failure of performance, error, omission, interruption, defect, delay in operation or transmission, computer virus or line or system failure. Transfer Agent services for DTC-eligible registered companies provided by Philadelphia Stock Transfer, a Carta affiliate. Carta Securities LLC is a broker-dealer and a member of FINRA and SIPC. Contact: eShares, Inc. DBA Carta, Inc., 195 Page Mill Road, Suite 101, Palo Alto, CA 94306.

© 2018 ESHARES, INC. DBA CARTA, INC.