ISOs are a type of stock option that qualifies for special tax treatment. Unlike other types of options, you usually don’t have to pay taxes when you exercise (buy) ISOs. Plus, you may be able to pay a lower tax rate if you meet certain requirements. Here’s what you need to know.
When a company gives you stock options, they’re not giving you shares of stock outright—they’re giving you the right to buy shares of company stock at a specific price. This price is called your strike price, exercise price, or grant price and is usually the fair market value of the shares at the time you’re granted your options. The hope is the value of the shares will go up and you’ll be able to sell them for (much) more than you paid.
Exercising stock options means purchasing shares of the issuer’s common stock at the set price defined in your option grant. If you decide to purchase shares, you own a piece of the company. You’re never required to exercise your options, though.
It’s important to have a strategy around exercising options—not just exercise and hope they end up being worth something—because exercising can have a very real (and potentially large) impact on your taxes. Here’s what you need to know:
Companies usually won’t allow you to exercise your stock options right away. Instead, you may have to stay at the company for a certain amount of time (usually at least a year) and/or hit a milestone.
The process of earning the right to exercise is called vesting. You can usually only exercise vested stock options. After you hit your vesting cliff (that waiting period mentioned earlier), you should be able to exercise your vested options whenever you want as long as you remain with the company (as well as for a time after you leave, depending on your company’s post-termination exercise period).
Some companies will allow you to early exercise before your options vest. If your company allows this, you can exercise your options as soon as you get your option grant, but they will continue to vest according to the original schedule.
If you leave your company, you can only exercise before your company’s post-termination exercise (PTE) period ends. After that, you can no longer exercise your options—they’ll go back into your company’s option pool. Historically, many companies made this period three months. However, some companies offer more generous PTE periods now, like seven years or for as long as you worked at the company.
Keep in mind that even if your company has a generous PTE policy, if you don’t exercise incentive stock options (ISOs) within three months of leaving, they’ll lose their favorable tax treatment and will be taxed like non-qualified stock options (NSOs) instead.
Early exercise is the right to exercise your stock options before they vest. Your option grant should say whether you can early exercise.
Early exercising could benefit you in a few ways:
- If you have ISOs, early exercising could help you qualify for their favorable tax treatment. In order to qualify, you need to keep your shares for at least two years after the option grant date and one year after exercising. Similarly, if you have NSOs, early exercising helps start your holding period sooner so you may pay the lower long-term capital gains tax when you sell.
- If you early exercise your options as soon as they’re granted, you likely won’t owe additional taxes (at the time of exercise) because you’re buying them at fair market value (assuming there’s no spread between what the stock is currently worth and how much you paid). Note: you must file an 83(b) election within 30 days of exercising to take advantage of this potentially favorable tax treatment. If you miss this deadline, there could be serious ramifications.
However, early exercising is inherently risky:
- When early exercising, you can’t sell some of your stock to pay for your shares—you have to use your own money.
- You also can’t predict whether your shares will increase in value. By waiting the usual one-year vesting cliff, you may get a better idea of whether you should purchase your options or not.
Keep in mind that when you early exercise, you’re more likely to trigger the $100K rule. This prevents you from treating more than $100K worth of exercisable options as incentive stock options in a year—any options above that amount are treated as NSOs for tax purposes.
Also, if you leave your company after early exercising but before the stock vests, your option grant usually gives the company the right to repurchase your early-exercised but unvested stock.
Depending on your company, there may be a variety of ways you can exercise your options:
- Pay cash (exercise and hold): You use your own money to buy your shares and keep all of them. This is the riskiest method because you’re not guaranteed to make a profit (or even get your money back). Plus, your money is tied up in your shares until you sell. However, it could pay off if your shares end up being worth a lot.
- Cashless (exercise and sell to cover): If your company is public or offering a tender offer, they may allow you to simultaneously exercise your options and sell enough of your shares to cover the purchase price and applicable fees and taxes. You can do whatever you want with the remaining shares—keep the rest or sell some.
- Cashless (exercise and sell): If your company is public or offering a tender offer, they may allow you to exercise and sell all your options in one transaction. Some of the money from the sell covers the purchase price plus applicable fees and taxes, and you pocket the rest of the money.
If your company is using Carta to issue securities, learn how to exercise your options here.
While exercising your stock options could pay off in the long run, it’s not a guaranteed way to make money. You should consult a tax advisor before exercising, and you should also ask yourself:
- Can you? Remember: unless your company allows early exercising, you can only exercise vested options. And if your company isn’t public yet, you’ll need the money to purchase them.
- Are your options in-the-money or underwater? If they’re currently underwater (worth less than your exercise price), it may not make sense to exercise right now.
- How is the company doing? Do you think the value of your company’s stock will rise or fall in the future? Beware of familiarity bias—overestimating the value of the stock because you’re familiar with the company.
- Can you sell your shares after exercising? If your company is private and isn’t likely to offer any tender offers or IPO soon, exercising your options is inherently risky—you’re paying cash for shares that may never become liquid.
- Can you afford the taxes? Depending on your situation (what type of options you have, how many you were granted, how much income you make, etc.), you may have to pay taxes when you exercise:
After you exercise your options, it can be hard to know when to sell. A lot of your decision will come down to your specific situation—again, you should talk to a tax advisor before exercising or selling. But it usually boils down to do you…
- Exercise and sell right away for a guaranteed profit but probably higher taxes?
- Hold on to them for at least a year for a potentially bigger profit (or loss) and lower taxes?
- Exercise and sell within a year (which is usually the most expensive option, tax-wise)?
If you want to maximize your profit, talk to a tax advisor before exercising and selling. While they can’t predict how your company’s stock will do in the future, they could help you figure out your options (pun intended) and suggest ways to minimize your tax liability.
DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”). This communication is for informational purposes only, and contains general information only. Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
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