Taxes stock options explained
Tips, Tools and Techniques to be a Better Entrepreneur. December 20, Jarie Bolander. I am not a lawyer nor an accountant. What I have done is some research. I have also been at a couple of startups where I had to figure out the paperwork. It obvious, but please do consult a qualified financial or legal adviser before making any stock option related decisions. If any of you out there are professionals, feel free to drop me a line with any corrections. Because they are free. Well, not exactly free but close to stock. Startups give out stock options to align their employees to the goals of the investors. Typically, a company will have a stock pool, after each round of funding, to give out to employees. So, stock options are a perk that tries to make employee a little more like owners. Before we explained into stock options, we should discuss the types of stock that a company can issue. The various types are:. Is a special class of stock that is only issued once, upon founding of the company. You usually buy this type of stock since the price is low on the order of cents and there are tax advantages long term capital gains for buying and holding it. As the name implies, preferred stock is special. Multiples and voting rights. The price and terms for preferred stock is set per round e. Eventually, all stock may convert to common, depending on the preferences listed at each round. This is important to know since it sets the total shares issued as well as the amount of participation the common shareholders will have in a liquidity event e. Being bought stock going public. In some cases, the preferred will take all the money and leave the common stockholders with nothing. Common stock is what your options are for. There are only two types of options that you will get at a startup — an Incentive Stock Options ISO or a Nonqualified Stock Options NSO. In IRS speak, an ISO is called a Statutory option while an NSO is called a Nonstatutory option. These type of options can only be issued to employees. They have certain tax advantages, the biggest being that ISOs are taxed on the sale of the stock not the exercise of the option. This means that you can exercise your options and not have to worry about taxes until you actually sell the stock. You do need to look into Alternative Minimum Tax AMT triggers since that plays by a different set of rules see below. All other options, at a startup, are typically NSOs. The main thing about NSOs is that they are taxed when you exercise the option. NSOs have the flexibility in terms of:. It is critical that you understand which type of options you have. The tax implications are real and severe if you do the wrong thing. ISO options are priced via a complicated process known in the trade options a A. The thing to keep in mind about option pricing is that it will be less than the present preferred round price. As the company gets closer to a liquidity event, the option price will converge to the round price. The rational for this is simple. Early in a startups life, the risks are high. Taxes this means is that early options are worth less since they are more risky. As the probability of a liquidity event gets greater and greater, the options become less risky — thus worth more. Stock options vest over time. Usually, options vest over a four year period with a one year cliff. There can be vesting triggers for certain events. These are all up to the company and board of directors. A typical vesting trigger might be a change of control or loss of title. In these cases, all of the options could vest right away. It really depends on the board. It is not unheard of to have fully vested options i. The IRS Section 83B is an election that allows employees to change how restricted stock options are taxed. Restricted stock usually comes in two categories:. When a company is founded, the Fair Market Value Taxes is really hard to determine and taxes low. This means without an 83B election, you would be paying AMT as the stock price appreciated at each round. So, all founders should buy their shares and file an 83B election. This ensures the most favorable tax treatment since it starts the long term capital gains clock and eliminates any AMT issues. The downside is that you can be out the cost of the stock which is most likely low if the company fails. Some option plans allow you to exercise your options before they vest. This type of exercise has to happen within 30 days. The tax advantage is that it starts the long term capital clock while the stock vests. See, this is kinda tricky. You really do have explained read that grant paperwork carefully to understand how taxes will be calculated. It is perfectly acceptable to ask your CFO to explain this to you or have them recommend a professional. To make it even more complicated, the IRS actually has two tax systems. Two different tax systems that have completely different rules. Exercising stock options will have tax implications for each system. Most people are used to this system because we all pay taxes. Options can be taxed two ways in this system: As of this writing, the criteria for long term capital gains is 2 years from the grant date and one year after the exercise date. AMT becomes a problem with ISO options because of the ability to hold without a taxable event. Remember, that an ISO is taxed when you sell the shares not when you exercise the options. If the AMT rate is more than your normal tax rate, then you pay AMT and not the regular tax rate. There is also something called a Minimum Tax Credit MTCwhich is the difference between the AMT amount and your normal tax amount if AMT is higher. This MTC can then be deduced in subsequent years. The options to take away from the whole AMT thing is to know that it exists and talk to your accountant. The vesting schedule is 4 years with a one year cliff. So, the math looks like this:. Jim exercises his vested ISO options. So, Jim needs to talk to his accountant to see if he will trigger owing AMT. If Jim holds his stock for more than a year after he exercises it, then he will owe long term capital gains when stock sells it. The complexity of the tax system makes it challenging to understand what you might owe when exercises options. Couple that with the changing nature of our tax system and you can see why 1 I am not an accountant and 2 why they get options so much. What you should do is become familiar with the terms so you can ask the questions. Listed below is a summary of things you should be aware or:. Stock Option Plan Article. IRS Publication related to taxable and non-taxable income. A good explanation on 83b elections. Excellent article on AMT and stock options. This work is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 3. Post Footer automatically generated by Add Post Footer Plugin for wordpress. EntrepreneurshipStartup founders stockISONSOstock options. Startup Stock Options Explained The Daily MBA http: This post was mentioned on Twitter by thedailymba: Startup Stock Options Explained http: The Daily MBA Tips, Tools and Techniques to be a Better Entrepreneur. Archives Frustration Free Technical Management Explained Basics Series About. Startup Stock Options Explained December 20, Jarie Bolander. Tweets that mention Startup Stock Options Explained The Daily MBA -- Topsy. 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