Ask HN: What are the tax implications of exercising startup options? | Hacker News Reader

Ask HN: What are the tax implications of exercising startup options?

93 pointsthrawoway64 comments

I've never been able to find a clear explanation of this, and given Coinbase's announcement today I thought it was a good time to learn.

So:

I get that if I leave my startup today I have 90 days to exercise my options.

I get that I'll have to pay the agreed 'strike price'

But everything after that is unclear to me.

Would I be paying tax as if I'd made capital gains in the amount of the delta between the strike price and the stock's value today? Would the stock's value today be based on the company's valuation at the most recent round of funding?

If the company goes on to raise more VC funding, would I be liable in future years for the 'capital gains' on this stock?

If the company went on to fail, would I be entitled to tax breaks for loss of stock?

etc.

I'd love to see a clear explanation of all this stuff from someone who's been through it or just knows it. Thanks!

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1. The day you exercise, the IRS will tax you income tax on the value between the stock's current value and your strike price. This is true even though you haven't made money from selling the stock yet.

2. If the company is still private, the stock's value is determined by the last 409(A) valuation for Common stock that the company performed, assuming that your options are for Common stock (which is very likely). The company must perform one of these valuations a year and should provide you with that amount upon your request.

3. Exercising the stock starts the clock for long term capital gains treatement. That is, if you sell the stock a year after exercising it, you will pay capital gains tax on the value difference between the sell price and the value at exercise.

Math wise:

* TP = strike price (the price in your option contract at which you buy the shares)

* EV = value of a share at exercise time, as determined by the latest 409A valuation

* SP = sale price of a share when you sell the stock eventually

* #S = the number of shares you have

* IT% = Your income tax rate

* CT% = Your long term capital gains rate

At exercise:

- You pay to exercise the shares: #S * TP

- You owe in taxes: #S * (EV - TP) * IT%

At sale

- You make: #S * (SP - TP)

- You owe in taxes, assuming you waited a year to sell: #S * (SP - EV) * CT%

I have a nominal amount of options from the job I just left. The amount of money doesn't sound like it's worth the hassle. Maybe I should just let it expire.

If you were granted ISOs (you were an employee and it is still within 90 days from your departure) and they are still available to you as such, exercise them as long as you're comfortable with the risk.

Despite the parent comment, unrealized earnings on the exercise of ISOs are not taxed as income.

They are not taxed as income but are subject to AMT, so can absolutely leave you with a large tax burden if you aren't cautious.

https://www.nceo.org/articles/stock-options-alternative-mini...

If it's a "token amount", then that's probably unlikely unless you have other large deductions (ex: mortgage, property tax)

It can be quite large too. However, you can recover that money a few $k at a time over the next several years if you are not subject to AMT (and don't sell the shares). Granted you will have to pay the taxes again when you sell the shares, but at that point it's capital gains (15%) so if it's a long term prospect it may well make sense.

You don't have to exercise all of them, just pick an amount that you're comfortable with. Think of it as insurance against "I worked for a company that later became a unicorn and all I got was this lousy t-shirt." How much would you pay for that, if anything?

In regards to #2: Does the company have to provide you with its last valuation? Can they force you to provide your own third party company valuation?

If you sell, they have to provide the value for tax reporting purposes.

Unless I missed something obvious and OP said that s/he has left their company and their options were converted to non-statutory options (NSOs), #1 is not true.

For incentive stock options (ISOs) #1 is not true and the earnings are not taxed as income. However, the earnings generated by your shares ((EV - TP) * #S) will be applied as an adjustment for the purposes of computing your alternative minimum tax (AMT).

Startup employees have ISOs, and are able to exercise them as ISOs until 90 days after they leave.

> Startup employees have ISOs

This is not necessarily true. I am a startup employee and I have NSOs.

Are you a 1099 or a W-2?

You're the first startup employee I've encountered in recent times who doesn't have ISOs. Are you a contractor / consultant who doesn't qualify for ISOs?

To answer both questions in this subthread, I'm a regular W-2 employee. I've been at the company since day 0, and I'm not sure whether all other employees get NSOs or not.

edit: just to make sure I'm not crazy I dug out my option agreement and it's definitely NSO.

The last line I thought about including in my GP post but didn't: "If you're a fulltime employee and you have NSOs, the founders botched the paperwork, plain and simple". As a founder myself, I think that's inexcusable in this day and age.

Condolences. That really sucks. :(

Well, two questions: what about employment at will? And, why would you prefer NSO over ISO?

Also true here. And was a regular W-2 employee.

In this case it seemed to be the case where one of the founders didn't know the difference when setting things up initially. After series A one of the investors pointed it out and new employees were given ISOs and old employees savvy enough to care were paid off.

What happens when after exercising, you sell the shares for a lot lower than the EV the year after? Can you claim a loss and deduct the loss from the taxable income the year you sold?

Is your tax deduction = #S * (EV - SP)?

Tax deduction is #S * (SP - Sale Stock Price).

This is equivalent to the standard: (Cost Basis - Sale Proceeds) calculation in a standard stock transaction.

Depending on whether this is a short term or long term loss, the following happens (taken from [1])

Short-term losses counterbalance those expensive short-term gains. What's left at the end of Part I of Form 8949 is the net short-term capital gain or loss. If there were no gains, then obviously the net would equal the total loss. Long-term losses are applied to long-term gains. The result, at the end of Part II of Form 8949, is the net long-term capital gain or loss. Again, if you only have a loss, then the net is a negative number. Next, you combine the short-term and long-term results on Schedule D. At this point, a loss in one section can offset a gain in the other section. For example, if you have a net short-term loss of $1,000 and a net long-term gain of $1,200, then you'll pay tax on only $200. If there's still a loss, you can deduct up to $3,000 from other income. If you had a really bad year and ended up with a net loss of more than $3,000, you can carry forward the leftover portion to next year's taxes. The unused loss can be applied to next year's gains, as well as up to $3,000 of earned income. A big loss can be used as a deduction indefinitely -- another important reason to keep good records.

[1] http://www.bankrate.com/finance/taxes/capital-losses-can-hel...

Ok so you can deduct as much as you want from any 'capital gains' you might have but only are allowed to deduct a max of $3000 per year from regular income, and the leftover capital loss just keeps on rolling over perpetually until you die?

Also the other thing that's screwed up about this is you pay taxes when you exercise the options at the normal income tax rate. But when you want to apply the tax deduction in the event of a loss, you're only allowed to do it on 'capital gains' for an unlimited amount and a max of $3000 on normal income. In fact it might be preferable to deduct it against normal income and keep rolling it over and just pay normal capital gains taxes (which is much lower than your income tax rate typically).

> and the leftover capital loss just keeps on rolling over perpetually until you die?

Pretty much. I have a $10K capital loss from a bad investment over 10 years ago. I simply keep rolling it forward until I have a capital gain to offset it.

Here is a thread in which I explain various technical points relating to the tax treatment of stock options: https://news.ycombinator.com/item?id=2623777

Adding to this on your specific question about loss: when you exercise options, your purchase price becomes the basis in your stock; if the company fails and goes bankrupt, for example, you can deduct the amount of the basis as a capital loss; this means you can offset this amount (i.e., deduct it outright) against other capital gains you might have in that same year or in future years (as part of a capital loss carryforward) but you cannot otherwise deduct it outright; in general, federal tax law in such cases allows you to deduct it at the rate of up to $3,000 in any given year, with the rest carried forward for future potential deduction (this is the capital-loss carryforward).

Hope this helps.

I really recommend _Consider Your Options_ as a great source of clear info for employees receiving any sort of equity compensation. One of my managers introduced me to it about 20 years ago. Pleased to see they've been updating it regularly since then.

http://fairmark.com/books-fairmark-press/consider-your-optio...

I stopped by to recommend this book too.

Here's another one: When should/shouldn't you exercise options when leaving a startup?

Obviously, if you're leaving Uber you'd be wise to buy your vested equity if you can.

Obviously, if you're leaving a company that is crumbling, you probably shouldn't.

But what about an earlier, Series A/B startup that's promising but still shows a lot of risk? Or what about a later stage startup that is doing well but not on a guaranteed path to a huge exit? On what information would you decide whether or not to exercise?

At the same time, if I was an early Uber employee and the difference between current value and exercise price is in the millions of dollars, then I'm on the hook for a tax bill I can't afford. Are there any solutions beyond taking out loans to pay my taxes?

Services like EquityZen can help find buyers for your common shares to offset the tax liability.

If you were an early employee and the difference is millions of dollars, I would suggest you stay at Uber until you can sell your shares. It's worth it at this point, and you getting a loan to exercise the shares represents a crazy risk.

Don't you have the option of sell to cover? You basically exercise all of the options, then sell a proportion to cover the taxes?

I was going to say the same thing -- but if your company is not yet public, that might not be easy to do.

Uber doesn't allow secondary sales to 3rd party but will repurchase your shares at their previous fundraising round price.

That's their current policy.

Some banks will give you a loan with the private shares as collateral. However, you may have a margin call on your hands if Uber has a downround.

If you were an early employee, you may have had the option to exercise your options early (while being an employee. Only being able to exercise your options when you leave is a myth -- one that I used to believe myself).

Would I be paying tax as if I'd made capital gains in the amount of the delta between the strike price and the stock's value today?

>> Yes, assuming you have not early exercised. This sucks.

Would the stock's value today be based on the company's valuation at the most recent round of funding?

>> Yes, the 409A valuation, which is generally ~30% of the valuation you hear about on TechCrunch for Series B-C companies. Investors received preferred stock. You have common stock.

If the company goes on to raise more VC funding, would I be liable in future years for the 'capital gains' on this stock?

>> Only when you sell it. Same as public stocks -- if you buy Twitter stock, and sell it in 5 years after it's gone up 2x, you have to pay cap gains only once after you sell.

If the company went on to fail, would I be entitled to tax breaks for loss of stock?

>> Not sure. The rules around this are pretty complex. Ask a lawyer.

Would I be paying tax as if I'd made capital gains in the amount of the delta between the strike price and the stock's value today? >> Yes, assuming you have not early exercised. This sucks.

>>>> So, if the company hasn't raised funding since I was offered my options, would I have zero tax liability for exercising my vested options?

No, the board can still increase the fmv value for two reasons:

1 - the company has executed well and increased their value;

2 - to ratchet golden handcuffs tighter

This is the single best source I've ever read on options, exercising them, etc: http://www.amazon.com/Introduction-Stock-Options-David-Weekl...

When I followed the recommendations (after checking with my accountant), I saved thousands of dollars and I'm still benefitting from that even now.

My only criticism is that I wish I had read it about 2 years earlier.

Let me answer a question you haven't asked but that is very relevant:

Q: How can I mitigate the risk of holding startup shares that are illiquid and whose value can drop to zero?

A: There are investment firms that will help you buy employee stock options and then split the proceeds with you. One of these is ESO Fund (esofund.com) and they are very nice people. They can help answer your other questions as well.

Pretty much depends on the country where you file your taxes. In general, you pay taxes on the difference between the nominal value (strike price) and the current market price of the shares because that's the compensation you received instead of an ordinary salary.

What happens afterwards depends on both if you sell the resulting shares at a profit or at a loss and when you sell them. Typically, taxation amounts to a lot less if you hold the shares for more than a year.

See https://turbotax.intuit.com/tax-tools/tax-tips/Investments-a... for more information on how this is dealt with in the US (including which tax forms to file).

I am not an expert.

That said, based on that article, there appears to be a difference between Incentive Stock Options (ISOs) and Non-Qualified Stock Options. You linked to information on that latter. Here is information on ISOs from Intuit: https://turbotax.intuit.com/tax-tools/tax-tips/Investments-a...

At a glance, ISOs appear to be more favorable, tax-wise, in the US - they trigger AMT but not "direct" income tax.

You pay the strike price, and you pay taxes on the difference between the current stock value and the strike price.

For example, if the shares would have been worth $1,000 when you joined the company, then the strike price for the options is $1,000. If those shares would be worth $10,000 at the time you exercise, then you pay $1,000 to the company to receive the stock, and then you pay taxes on $9,000 (the difference) to the government. So you might be looking at like 3K in taxes in that case.

You owe the taxes for the current tax year. You owe the taxes regardless of whether or not the company succeeds. Company could fold right after you exercise and you'd still owe Uncle Sam 3 grand.

(Then there are also capital gains taxes to worry about after this. I am only describing your immediate tax burden.)

if the company tanks right after you exercise, can't you deduct the losses?

This happened to a lot of people in the Valley after the dot com bust. They exercised their options, triggering a tax liability, and then the shares tanked, leaving them with no money to pay off the liability. They could only deduct $3000/year. Lots of people were in a lot of trouble, but I remember hearing that finally the IRS made a change so that this wouldn't affect you anymore.

You should be able to deduct the loss, but I'm not sure how that plays with the tax owed, since the loss is a capital loss and you're paying tax on an object of specific value (not a capital gain). It might not simply cancel out.

I was under the impression you only pay taxes if you trigger the AMT. If you do not trigger the AMT then you will just pay your ordinary income taxes on salary. Is that not the case?

Good question. Our lawyer has suggested that anyone exercising options should be prepared to pay taxes on the difference, but it would be interesting to know if you can avoid it if your other income is low.

But, with NSOs, if you file an 83(b), you avoid tax, correct?

83b only avoids future capital gains tax, not tax on the shares being acquired at the time of exercise. In my above example, an 83b doesn't save you from having to pay taxes on the 9K value difference, because that's not considered a capital gain.

The only way to not be taxed at the time of exercise is if the share price hasn't changed since you joined the company.

Q: What are the downsides to Coinbase's approach?

Also, if you early exercise your shares, do not forget to file an 83(b) election within 30 days of your exercise. This also applies if you end up founding a company or are issued restricted stock awards.

Surpiringly just one mention of the 83(b) process in this fairly well populated thread. Here's a good explanation of why you must know this to avoid a huge tax bill in case of your stock options becoming valuable some day. https://www.cooleygo.com/what-is-a-section-83b-election/

If I understand the question correctly, and it's about what to do when leaving the company, 83(b) is unnecessary. An 83(b) election says that you are choosing to recognize paper gains today that the IRS would normally require you to recognize when they are no longer subject to a substantial risk of forfeiture. If he's leaving, he must be exercising vested options, so there is no risk of forfeiture, so no need for 83(b).

An 83(b) election is critical for unvested stock, i.e. "early exercise".

I have started to write a series of posts on my blog regarding this very topic. So timely question.

> I get that if I leave my startup today I have 90 days to exercise my options.

The number of days to exercise depends on your contract. The typical number is 45 days. Pinterest's number for employees that have more than 2 years of service is 7 years. This number is not set by law, and can be set to anything the founders/investors agree to.

The 90 day number you are thinking of is the law stating that ISOs become nonincentive options when not exercised after 90 days after termination of employment.

> I get that I'll have to pay the agreed 'strike price'

You pay the "strike price" * "number of options you wish to exercise"

> Would I be paying tax as if I'd made capital gains in the amount of the delta between the strike price and the stock's value today? Would the stock's value today be based on the company's valuation at the most recent round of funding?

Assuming you were awarded ISOs, you do not owe capital gains tax under "regular income tax" upon exercise. You only owe taxes upon sale of your stock that you have attained through exercise, at some future date.

However, depending on your amount of gains, other income, and your effective tax rate, you may owe tax under AMT. Consult a CPA with experience in this. It should be simple for them. (I believe you get some tax credits for this AMT payment when you end up selling your shares in the future)

The company's stock's value is set by the BoD meetings. This may or may not be the same as the previous round of funding.

> If the company goes on to raise more VC funding, would I be liable in future years for the 'capital gains' on this stock?

You are only liable for "capital gains" when you sell the stock.

> If the company went on to fail, would I be entitled to tax breaks for loss of stock?

Good question! I hadn't thought of this one. My guess here would be "yes", you would be able to claim a capital loss equal to the amount of money you paid to acquire your stock.

How does the tax situation change if you're a non-resident alien during the whole process? Is there any difference in the tax rates?

Another question along these lines, since OP's question seems well-answered:

If a startup employee has 90 days to exercise options after leaving a startup, what happens if a liquidity event happens during that 90-day window? Specifically, I'm wondering whether a cashless transaction is possible, particularly if it is a cash deal.

This article is more than a decade old, but a lot of content is still relevant. http://web.mit.edu/tytso/www/OPTIONS-HOWTO/OPTIONS-HOWTO.htm...

Many startups have a clause in their offer letter that promises to "recommend that N options be granted at the next board meeting." It's a formality, but it doesn't always happen. Make sure those options were actually granted before you think about how to exercise them.

Are you a founder with actual stock, or an employee with stock options? I assume employee here.

As an employee if the company value is below the strike price you wouldn't exercise your options because it leads to a loss. Exercising options is voluntary.

If you use the options to buy stock and hold it then profits and loss are subject to capital gains tax. Not sure what the minimum holding timeframe is in the US. In my experience most employees don't have the amount of money to buy the stock for long-term investment. To my best knowledge, losses are tax-deductable. Remember even if you own stock there is hardly an open market to sell like there is with publicly traded companies.

As an employee if you exercise the options and you make a profit then the HR/payroll/accounting department will add that as income to the W2 and transfer the money minus income tax to your account. When you do your taxes you fill in the various fields of the W2 into your tax software. That's the best case and usually just takes you a couple of signatures.

Also, please add more questions if you have them. I'm sure I didn't ask all the pertinent ones, and if there's any place to find people who can answer, it's probably HN.

I'm glad you ask questions. I've worked with many people who didn't understand the contracts they signed. Or thought they "owned" options (if the company fires you you generally loose the options).

Is anyone able to give some insights for non US citizens that have options of an American company but work overseas with no american employment contracts. Thanks!

Go ask a professional instead of an internet chat forum.

I'm well aware that I should take internet forum advice with a grain of salt. But, I thoght that sparking a discussion about the complexities and circumstances in an internet forum that has a very wide, deep pool of experience in this area might shed light on some interesting things. So far, it has.

It's hard to find professionals who have better knowledge than the MAX() of the people reading this thread.

Imo it's even hard (and costly) to find professionals who have enough exp in general.

Agreed. I had an options exercise in the hundreds of thousands once and my tax accountant, who came highly recommended but had relatively little experience with options, completely screwed it up until I caught it. I got a new accountant.

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