But before purchasing shares, startup employees need to be aware of the potential tax implications. There’s no one best time to exercise stock options, and just because you can, doesn’t mean you should.
This article will discuss some of the pros, cons, and key factors to consider when considering how and when to go about exercising options.
Key Takeaways
- Exercising stock options means buying shares of company stock that were granted to you in an option grant. Your purchase price is called the exercise or strike price, and it is fixed.
- Exercising Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs) have different tax implications.
- Stock options can be exercised with cash or with shares of stock.
- Early exercising can lock in favorable tax treatment if the plan allows it, starting the holding period early.
- The best time to exercise options is when the spread between the exercise price and the current value is low, along with the exercise cost itself.
Understanding stock options
If you are new to managing stock options, please refer to this article on how stock options work. Stock options are a form of equity compensation. There are two main types of stock options: incentive stock options (ISOs) and nonqualified stock options (NSOs). Each has different tax implications. Stock options are exercisable when they vest, and sometimes even earlier.
What does it mean to exercise stock options?
To exercise stock options means buying shares of stock that were granted to you by your employer. A stock option grant gives employees the right to buy company stock at a set price, called the strike price or exercise price.
How to exercise stock options
There are three main ways employees can exercise stock options. For simplicity, assume the strike price is $1, current market price is $5, and there are 100,000 stock options. Ignoring taxes, but note that any tax withholding can often use the same exercise method.
Typically, a company must be publicly traded for options two and three. But exceptions exist. For example, when a private company does a tender offer, it’s usually a cashless transaction, but any new exercise and holds are still monetary.
With cash (monetary)
Buy shares with cash from your bank or brokerage account. Startup employees will have a short form to fill out (a sample will be with your grant documents). Example: write a check for $100,000, receive shares of the company’s stock currently worth $500,000.
Net exercise of options (exercise and sell-to-cover)
Use a portion of your granted shares to pay for the stock and receive the net amount of shares. Example: 20,000 shares are immediately sold to cover the $100,000 purchase price; the company delivers you 80,000 shares (currently worth $400,000).
Cashless (exercise and sell)
Exercising unvested stock options
Exercising unvested stock options is called an early exercise. Especially when the timing is “ideal” as explained below, it’s worth considering an early exercise of unvested stock options.
When you exercise early, you purchase shares before they vest, potentially locking in favorable tax treatment (often with the help of an 83(b) election) and starting the holding period. There are other considerations and not every company offers this, so learn more about how it works (and which type of options are better candidates) before exercising options early.
Tax implications of exercising stock options
Why does the timing of stock option exercises matter? Taxes, for one. The tax implications of an options exercise will depend on the type of stock options you have. If you are new to stock options, please review the article below for a more robust discussion on how stock options are taxed at exercise.
Incentive stock options
Incentive stock options (also called statutory options or ISOs) have tax benefits if the holding period is met. However, exercising and holding shares through the end of the calendar year can trigger the alternative minimum tax (AMT). This happens when there’s a big spread between the market value of the stock at purchase and the strike price.
AMT tax rates range between 26% -28%. The employer is not required to withhold any amount at exercise or sale to cover any potential tax liability. Think about the AMT like pre-paying tax. In future years when not subject to the AMT, you can receive an AMT tax credit.
Tax after exercise: If you hold the shares for at least 2 years from the grant date and 1 year from exercise, the entire gain will be taxed at more favorable long-term capital gains tax rates. Different tax treatment may apply in other situations, including state taxes. This can be quite complex, particularly if you’ve moved since the option grant.
Nonqualified stock options
With nonqualified (also called nonstatutory options and NSOs), at exercise, the spread between the value of the stock price and the strike price is subject to ordinary income tax. Federal income tax withholding is generally required at the time of exercise. If the spread is under $1M, the federal statutory withholding rate is 22%, if above, it’s 37% through 2026. State income tax withholding may be required and payroll taxes (Social Security and Medicare) can apply.
Tax after exercise: Any subsequent gain or loss on the company stock from the date of exercise is a short or long-term capital gain/loss depending on your holding period.
Equity Compensation Certified Financial Planner Professionals
The best time to exercise stock options
Most decisions around equity compensation are complex as it involves many aspects relating to your personal circumstances/grant. Keeping all this in mind, here are several key factors to help inform your decision about the timing of your stock option exercise.
What’s the best time to exercise stock options if you work for a startup? In the best-case scenario, employee exercises occur at a time when:
- The strike price is very low (like pennies), thus minimizing the cash outlay
- The strike price is equal (or very close) to the market price (essentially the 409a value), thus minimizing or negating taxes
For early startup employees, stock option grants often have a very low strike price, as the company is new, so the fair market value reflects that. This makes buying the shares quite affordable and reduces risk for the option holder if the potential upside never materializes. And when the spread between the exercise price and current value of the stock is small or zero, it’s a huge advantage for tax purposes, as there won’t be any federal taxable income for NSOs or AMT income for ISOs.
Another bonus: if your shares meet the initial criteria for Section 1202 Qualified Small Business Stock, exercising may be imperative to increase the likelihood that your shares may ultimately qualify for a federal capital gains exclusion of up to 100%!
Since the fact pattern won’t align for all employees, it’s important to discuss your employer grants and financial situation with your financial and tax advisor.
The decisions around exercising options at public company or before an IPO also require careful planning and consideration.
5 Tax Planning Strategies for Exercises of ISOs and NSOs
Especially for early employees of a startup, there are some great ways to reduce or even eliminate all taxes on the exercise and even sale of stock options. When purchasing any investment asset, you’ll always need to consider the merits of the investment. So all else equal, you should believe in the overall outlook of the company.
Here’s an overview of 5 exercise strategies for incentive and nonqualified stock options. An expanded discussion of these strategies can be found here.
1. Regular Exercises
- Works for: ISOs and NSOs
- Best when: strike price is low; little to no taxable spread
- Key considerations: cash requirements, spread at exercise, AMT
2. Exercising ISOs with Income from Stock Sales or Vesting RSUs
- Works for: ISOs
- Best when: you have significant taxable same-day sales, regular income (including vesting RSUs), or short-term capital gains for the year
- Key considerations: cash requirements, spread at exercise, AMT
3. Early Exercise With An 83(b) Election
- Works for: ISOs and NSOs (NSOs may be best)
- Best when: you will fully vest; strike price is low; little to no taxable spread
- Key considerations: cash requirements, vesting, spread at exercise, AMT
4. Exercising After a Down Round or Sinking Stock Price
- Works for: ISOs and NSOs
- Best when: the taxable spread narrows
- Key considerations: cash requirements, spread at exercise, AMT
5. Exercising When Meeting Criteria for Qualified Small Business Stock
- Works for: ISOs and NSOs
- Best when: qualifying for tax-free sales is always a good thing!
- Key considerations: holding periods, documentation, exercise timing
Learn more about tax planning for ISOs and NSOs here.
Support from Equity Compensation Specialists
Having a lot of stock with your company can be a tremendous opportunity to build wealth. But paper profits can evaporate without a tax and financial strategy in place.
This may be your first time exercising stock options, but it’s not ours! Darrow Wealth Management is a fiduciary advisor for equity compensation. When stock options collide with liquidity events, we really shine. Contact us to schedule a call and discuss your situation.
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FAQ: Exercising Stock Options
The grant date refers to the date the company’s board approved your stock option grant. It will be on the first page of your stock option grant document. The exercise date is the day you actually exercise your option to buy the shares. You control the timing and should keep records of all your exercise dates.
With a net exercise of options, also called exercise and sell-to-cover, the broker sells some of your stock options to pay for the exercise and any mandatory tax withholding. You receive the net amount of shares in your account.
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