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Option Exercise Costs: Everything You Need To Know

We’ve explained stock options from the perspective of employees and founders. Here, we’ll take a closer look at the costs associated with option exercise and how you can defer or minimize those outlays.

What are the costs associated with exercising your options?

In general, there are two direct costs associated with exercising options: (1) the cost of converting the options to share, which is paid to the company, and (2) taxes paid to the government.

Exercise costs

The first cost is straightforward: You have to pay the company for the shares you are being given. Say you are granted 10,000 options when you start your job at a strike price of $1.00. If, after one year, you would like to exercise all of those shares, you may do so at that strike price, even if the company and the shares have become much more valuable. In that case, you’d be purchasing 10,000 shares at $1.00 each, for a total exercise cost of $10,000. (Incidentally, you would be paying that amount to the company, since you are buying those shares from the company.) If you waited longer to exercise — say, another couple of years — your exercise costs will go up if the company’s valuation has gone up.

Taxes

The second cost is more opaque, and it is the source of most of the questions we field about option exercise: Taxes. Wait, you might be thinking: When I exercise my shares, I’m not actually receiving any money. Why would I be taxed? This is a good question, and the answer is why exercising valuable options can create all sorts of liquidity issues. In short, although you technically won’t owe regular old income tax on your options, exercising can — indeed, usually will — cause you to be subject to income tax (in the case of NSOs) or the Alternative Minimum Tax (in the case of ISOs).

How are option exercise taxes calculated?

When you exercise your options, you are buying shares that are worth something. This is called the Fair Market Value (FMV), and it changes over time (hopefully increasing!). Even if the FMV increases over time — say, to $10.00 — you are still entitled to buy the options at the strike price when they were granted (in our example, $1.00 per share). That’s great — you’re paying less for the shares than they’re worth. But the IRS is always looking for its cut, and the government will tax you on any value that you get from your employer. In this case, that’s the difference between the FMV of the shares at exercise and the strike price you pay the company for the shares.

Let’s return quickly to our example. Say you received 10,000 shares at a grant price of $1.00 apiece, and you exercise them all at a price of $10.00. You pay $10,000 for the shares, and you’re receiving shares worth $100,000. To the IRS, then, you have a gain of $90,000 — an imaginary gain, to be sure, but still a taxable gain in the IRS’s eyes.

How much you will be taxed depends on whether you have ISOs or NSOs. For ISOs, it will be the Alternative Minimum Tax. For NSOs, it will be the ordinary income tax rate. What, exactly, these taxes will be is outside the scope of this article, but suffice it to say that the bill can be substantial — often as much as 35-50% of the difference between what you paid for the shares at exercise and their value, or between $30,000 and $45,000 in our example. (Like the costs of exercise, these taxes would likely go up if you waited longer to exercise, since the value of the shares, and your paper gains, would be higher if the startup becomes more valuable.)

Are there any other taxes associated with stock options and the resulting shares?

Unsurprisingly, yes: You will be taxed on any appreciation when you sell the shares. Returning to our example, you exercised at $1.00. Say the company is acquired or goes public at $100.00 per share. If you sold at that price, you would pay at that point on your gains — the $99.00 that the shares have appreciated since they were granted (though you will receive a credit for any taxes that you paid at exercise).

Here’s a diagram:

Different prices when selling an option

How can you save on these taxes when exercising?

Recall how options are taxed: You’ll pay taxes on (1) your paper gains when you exercise; and (2) your actual capital gains when you sell. Fortunately, there are options for saving on both of these fronts.

Early exercise

The main way you can take control over these variables is by thinking critically about the timing of your exercise. In particular, if your company allows early exercise (before your shares vest), you can elect to exercise your options right when they’re granted. If you do that, then the fair-market value will equal your grant price, and you won’t have any gains, even on paper. No gains, no taxes. Plus, the earlier you exercise, the lower the value of your shares and the less exposure you will have to the Alternative Minimum Tax (assuming that the value of your shares will grow over time).

Capital Gains

The second way to reduce the taxes on your shares is to qualify for favorable tax treatment when you sell. What tax rate will you pay on your gains depends on what kind of options you have and, critically, how long you have held the shares, plus a few less common rules that we’ll talk about in a moment.

No matter which type of options you had, if you hold the shares for less than a year after exercising, your earnings will be treated as short-term capital gains, which are taxed at higher rates. If you hold for longer than a year (and, in the case of ISOs, sell at least two years after your grant date), the returns will be taxed at the more favorable long-term-capital-gains rate.

In this example, on a $1m sale of the startup equity, early exercising may be the difference between a Californian keeping $650,000 (or more with tax planning that we share further down) or $500,000 if they do not exercise their shares till the sale!

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