We’ve all had that moment when it’s the end of the year and you’re about to do your taxes. It kind of feels like spinning the wheel on “Wheel of Fortune” and hoping that you don’t end up on “bankrupt.”
Equity can be really exciting because you’re building wealth, but anytime you’re building wealth you have to make sure you’re thinking about taxes, because the last thing you want when it comes to taxes is to be surprised.
Earlier in lesson three, we talked about the different kinds of equity your company might give to you. There were stock options and there were RSUs. The most commonly issued type of award for private tech companies is stock options—specifically, incentive stock options, or ISOs. That’s the type of equity Iris got at her company, so for this lesson that’s the type of equity we are going to focus on.
Iris has been granted all these ISO shares. She’s vested them, exercised them, and now she wants to sell them. Depending on when and how she does that, she could qualify for some preferential tax treatment. Or in other words, she could qualify for a friendlier tax rate on the money she makes.
But in order to receive this treatment she has to have what’s called a “qualifying disposition.” So what’s that? Well, to have a qualifying disposition Iris has to hold onto her shares and not sell them for at least a year after she exercises them, and two years after the option grant date. If she doesn’t meet those holding periods, she’ll be subject to a disqualifying disposition and she won’t get the preferential tax treatment.
OK, so if Iris has a qualifying disposition, then what is the preferential tax treatment she has access to? It’s called long-term capital gains, and the tax rate on long-term capital gains tends to be anywhere between zero and 20%. If Iris sells any shares that don’t meet the holding requirements, those shares will be subject to short-term capital gains, which is taxed at ordinary income rates.
So as you can probably tell, Iris could see some serious tax savings by meeting these holding requirements and having a qualified disposition. Let’s walk through a practical example.
If you remember Iris’ equity grant agreement, her company granted her 4,000 ISO shares with a strike price of a dollar. Now fast forward a year, and the company’s doing really well. They’ve got a 409A valuation done, and the share price now sits at $5 a share. Right at this point Iris hits her one-year cliff, so this means she vests a thousand of her options all at once. The share price has gone up to $5, but Iris’ strike price is locked at $1. So if she wants to exercise her options, she can do that by paying $1 per share.
Let’s say she does it. She exercises 1,000 shares at $1 apiece. Now I want to pause really quickly and point something out. Notice right here there’s a spread, or a gain, of $4. That’s what we talked about in lesson five. Iris may be subject to some taxes on this spread. This exercise of options may subject Iris to a tax called AMT, or alternative minimum tax.
Now AMT is a whole beast of its own, so we’re not going to talk about it just yet, but what’s important to know is that it comes into the picture right at this moment. So lock that term away in your mind—AMT—and we’re going to come back to it in just a few minutes.
But for right now, let’s stick with Iris as she goes through with exercising her options. So Iris just exercised. Now fast-forward another year. At this point, it’s been one year since Iris exercised her options, and two years since she received her equity grant in the first place. This means Iris has met all the holding requirements, and she now has a qualifying disposition, so she decides that she’s ready to sell her shares.
At this point, the company has done another 409A valuation and the share price has gone up to $10 per share. She sells 1,000 shares at $10 a share, so her gross payout is $10,000. But then you have to take into account the money she paid to buy the shares—or exercise—in the first place. If you remember, that was $1,000. So subtract that from her gross payout, and Iris ends up with a difference of $9,000. Assuming Iris did everything right, this $9,000 may now be taxed as long-term capital gain versus ordinary income tax.
OK, so a minute ago we mentioned AMT. Now we’re going to revisit it. AMT is something that a lot of employees don’t even know exists, so when they exercise their shares, suddenly they get hit with taxes at the end of the year—even if they haven’t sold them yet. And that is why AMT is important. Depending on when you exercise and sell, it can have a real impact on your taxes.
So let’s talk about it. Right off the top, it helps to know some history. Basically in the distant past, people would use all kinds of creative writeoffs to reduce their tax obligation down to extremely low numbers. What this looked like practically was people with really high incomes were writing off all these various things that allowed them to more or less avoid paying taxes altogether.
So in the 1960s the government stepped in and said, “Hey, depending on your income, we’re going to set up a minimum amount that you have to pay in taxes, just as a base. You can write off everything you need, but this is the floor. You can’t go any lower.” This is defined as alternative minimum tax.
It’s a separate completely alternate way of calculating your tax obligation, and how it works is when you do your taxes you calculate both versions at the same time. You do your ordinary income and your AMT. At the end of the day, whichever one yields a bigger tax obligation, those are the taxes you pay. What’s important to know about AMT is that your company isn’t going to withhold this on your behalf, so you’re solely responsible for it.
That’s why if you look back at an example with Iris, she’s got this spread of $4 per option when she exercises her options. So again, multiply that spread by the number of options she exercised, and even though she hasn’t sold any of her shares, she’s had a gross gain of $4,000. Subtract the amount she paid to buy the shares and her net gain on paper is $3,000. Iris’ AMT obligation will include taxes on this $3,000 net gain.
And mind you, this is just when she exercises, she hasn’t even sold any of her shares at this point. So if you remember, both things are going to be calculated at once: her AMT which includes the $3,000 net gain, and her ordinary income. And whichever one’s higher, that’s the tax obligation she’s going to have.
This became an infamous issue during the dot-com bust in the early 2000s. Employees had exercised really large numbers of ISOs. They hadn’t sold them yet, but their companies were growing, and on paper they had really large gains. Then the bust happened and the companies went out of business. So those employees never had the chance to actually sell their shares. But the problem was the IRS still wanted the gain for AMT, which for some people was in the hundreds of thousands of dollars.
Now it bears mentioning that for most people, it won’t be that extreme, but it does go to show why AMT is such an important consideration when you think about exercising your options. You always want to factor in planning, and if needed, make sure you set aside money to pay year end AMT obligations.
Generally, you also want to do some downside planning for exercising options altogether. Remember, gains are not guaranteed. All investment decisions, including whether or not to exercise options, carry risk. At the end of the day, this is all really complicated stuff. That’s why we always recommend that before you exercise your options you speak with a tax professional and legal advisor in order to understand what your liabilities might be.