Filing Taxes After Exercising Start Up Options | Hacker News Reader

Filing Taxes After Exercising Start Up Options

bradygentile.com

96 pointsremyg44 comments

I would add one thing: if you're really going to exercise options before you can sell them, which is what this article's about, you really should calculate the tax consequence beforehand. As is only hinted in the article, the AMT can be enormous if the valuation has grown a lot since the grant date.

Also an issue with NQSOs, though AMT doesn't enter the picture just regular cap "gains" (I use the term loosely because the IRS doesn't care that you have no way of actually realizing that gain as cash).

Semi related to this blog post:

A lot of people don't realize that you can exercise ISOs before they vest. If you are sure that you are going to be exercising your options there is no reason to wait until they vest and, in fact, there are disadvantages to doing so.

As soon as you get your options (within 30 days. there is a time limit.) you tell your company you want to exercise then and file and 83B with the IRS indicating that you have done so. This avoids potential AMT taxes at the time of exercise and starts to clock on making your gains long term capital gains which are taxed at a lower rate.

IIRC, this is on a company-by-company basis. Only some companies offer early exercise (i.e., exercising your options prior to vesting).

It's a great practice to do, if you believe the company is going to do well. Goes a long way towards minimizing the AMT burden.

Yes, this is true. I will add that I have found that if you ask hard enough there is a good chance that companies that say that they don't do this at first will end up allowing you to do so. There's really no good reason for them not to.

I would imagine that the reason many companies are reluctant to do this (or at least don't advertise it) is because advising employees whether they should or should not do it amounts to giving financial planning advice. Asking hard enough probably means showing you have weighed your own financial situation and understand the risks.

There is one "good reason". To hand cuff and trap employees. I hope that the incidence rate for this is low, but it must be non zero.

(I think pre series A companies should give out RSUs and not options to avoid these situations)

There actually are other non-nefarious reasons. When employees exercise they become shareholders, and certain securities law regulations come into effect. A young startup might want to defer those until they are big enough to handle the administrative overhead.

Also, while it's a tremendous tax benefit and pretty much a no-brainer to early employees, once the strike price constitutes an investment of tens of thousands of dollars, all of which could be lost, it's not necessarily a popular or prudent choice for later employees. So then it becomes this thing that only the early employees get, which perhaps might lead to some resentment and morale issues. Just some issues for companies to consider.

Good overview of the pros and cons here: http://www.startupcompanylawyer.com/2009/01/11/should-a-comp...

the "early exercise" that harryh refers to carries the same handcuffs as an option grant - a (typically) four year vesting schedule. The difference is that instead of vesting "the option to purchase shares" you vest the removal of the option for the company to repurchase the shares it sold you, at the original purchase price. In other words, if I exercise early and leave after two years, the contract states that my employer can purchase my unvested shares back at the original price.

An option grant where the spread has become large enough that the employee cannot cover the tax burden upon exercise effectively handcuffs said employee to the company until a liquidation event.

Early exercise minimizes the tax burden reason for handcuffing.

sometimes startups put the strike price below current valuation if they've raised at least their A round.

They cannot. Backdating or artificially deflating the asset price is no longer legal.

What's likely to happen is new investor extracting some special terms for their investment, receiving preferred stock that's valued higher than common stock. The company then turns around and uses the product of preferred stock price and total number of shares outstanding as the new valuation number that's "leaked" to the press.

The 409A valuation of the common stock is a separate dollar figure, though.

What happens if/when you leave before all your ISOs have vested? Do you forfeit the exercise price for the unvested stuff, or does the company typically refund it?

the company refunds it. technically, what you generally agree to when you early exercise is to give the company the right to purchase the unvested shares back from you at the original purchase price.

The caveat is that you lose whatever taxes you paid on exercising unvested shares. Gotta be really careful with that, as the taxes could cost way more than the exercise itself.

The idea with early exercising is to not pay any taxes because you exercise at the strike price.

Sure, but there are instances when that's not the case, e.g. early exercise implemented by company after the fact, or holding off buying until you're reasonably sure that the shares won't tank next month.

Close, but not quite. The time limit is to when you have to file the 83b with the IRS to document the early exercise. The rest of what you said applies.

The key thing is that you want the delta (between exercise price and FMV) to be as small as possible. Of course, none of that matters if the company isn't going to succeed anyway.

* And yes, I have done this. I early exercised all of my shares at Twilio.

Slight clarification:

The key thing is that you want the delta (between exercise price and FMV) to be as small as possible — at the time of exercise.

If you exercise any time but (effectively) immediately upon being granted your ISOs, you're liable for the taxes on the delta between your strike price and the FMV at time of exercise. If you exercise immediately, that should be zero. But it's that delta — between strike price and FMV at time of exercise — that can factor into AMT in a particularly surprising, and often very unpleasant way.

Forward-exercising and making an 83(b) election also starts the clock ticking on capital gains tax. Effectively, if you're starting at a brand new unicorn, and exercise your entire grant on Day 1, you'll only owe Long-Term Capital Gains tax (15%, instead of regular income rates — or, worse, AMT) on the entirety of your (initial) option grant, the day you hit your vesting cliff.

IANA Tax Attorney, or Accountant. Caveat lector.

You're totally right. I mis-spoke (mistyped?). Thanks for the correction.

To state the obvious, the downside of early exercise is you might lose that money if the company does poorly.

The downside of early exercise is if you leave before vested and your employer repurchases the shares, you're out the taxes you paid (minus some deductions in future years that will offset other gains but will still be painful for most people).

This also requires that you have the money to pay for it at that moment too right?

In other words - I get 10k options at $1 strike price, in order to exercise within 30 days I need to pay $10,000. Correct?

You'll need $10K to buy the options from your company. That's "Day 1". By Day 30 you need to file 83b with the IRS. And when it's time to pay your taxes for that year, you'll need to pay the IRS the taxes on the "income" you got from exercising the options. That is, if the strike price is $1 and the current market price for the shares is $3, the IRS sees that as a $20K income you made (even though you don't actually have liquid money).

If the delta between the strike price and the market price is large enough, you might actually pay the IRS more than you'll pay your company.

So this can totally screw you if:

Day 0 - Company is worth $1B (pay $10k)

Day 365 - Company is worth $2B (pay taxes on $10k in "income")

Day 900 - Company sells for $50M (your stock is probably worthless due to liquidation preferences)

My understanding is that Day 0 is the only important day here (or actually, Day 365 doesn't matter). You pay $10K on Day 0 and you earn no "income", so you do not owe any tax.

On Day 900, if your shares are worthless, you can then take that $10K as a long-term capital loss. If and how that can carry forward is something you'll want a tax accountant for.

Here's some of what the IRS has to say about that, but of course - Get an Accountant: https://www.irs.gov/uac/irs-reminds-taxpayers-they-can-use-s...

Thank you for this, I exercised stock options last year but never received form 3921 from my ex-employer. What are my next steps here? I reached out to my employer, but I doubt they'll get back to me. Do I need to report this to the IRS?

I think you should at least mention the option of hiring a professional accountant.

Anyone have a professional accountant in San Francisco they would recommended for this sort of thing?

Would love an accountant rec in NYC as well.

I have one in Marin I recommend. Email is in my profile.

He does - last thing he leaves the reader with.

There should be a guide overall on how RSUs work, especially in an early-stage context, for startup employees. I feel like people toss percentages around but don't grasp the meaning of what they're about.

This guide basically convinced me I need to talk to an attorney and accountant haha.

As I understand it, RSUs are a lot simpler. You don't need to do anything when they are granted to you. And when they vest, they count as normal income at the value at vest time.

Is there ever any reason to exercise options with a FMV below the strike price? I know someone who left her job and is in that situation (private company), seems like she should just ignore them entirely and let the options expire. I suppose if she had good reason to believe the company would bounce back they'd be nice to have, but otherwise it seems just like buying stock for more than the going market rate.

Access/control is the only reason I can come up with.

Access: One often doesnt have an option to buy shares in a private company besides the granted options.

Control: If one had 49% of share and options as you described for 2% one could take control of the company? Extremely edge case.

She could hold them until just before the expiry to see if they do bounce back in the window.

If some random person on the internet wants to help me out. If I exercised my options, and the company was purchased later the same year and my common shares were purchased for $0 (preferred shares took all the money, leaving common with zero), how do I file this loss?

I'm by no means an expert, but I believe you should ask for a 1099B with proceeds at $0 and cost-basis at either $0 and marked as not reported, or with cost-basis equal to your expense. If the former is the case (not reported), you report the cost-basis yourself.

Thanks for the info!

It is ridiculous to charge taxes based on fictitious paper valuations. I think taxes should be imposed only when shares are sold resulting in cash.

If you act in a certain way, you are free to accomplish that for yourself. Only ever do a same-day exercise-and-sell. Never exercise early. Never exercise-and-hold. Enter into a 10b5-1 that ensures you sell any shares immediately upon vesting. I think that covers all the cases and you're protected against being taxed on paper-only valuations.

That doesn't mean that your preference should preclude other people from acting differently.

But it does mean that one has to abandon said "fictitious" value if ever leaving a company (usually 90 days) .

This opens a number of loopholes related mostly to income and estate tax avoidance. Shares of companies can be transferred to heirs for an arbitrary strike price and if they're never sold, there's no capital gain tax, no income tax and no estate tax liability generated. Rinse and repeat for multiple generations.

AMT is a quick fix to allow the government to tax the transfer of assets per se.

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