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How to estimate your tax liability when exercising stock options

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If you’re planning to exercise your employee stock options, you’ll need to calculate your related tax liability so you have a firm grasp of your total cost to exercise.

In select cases, you might be able to exercise your stock options without paying any additional taxes. If you exercise them early enough, you might even qualify for additional tax benefits down the road.

If you fail to calculate your stock options-related taxes, you might find yourself owing state and federal tax authorities an unexpectedly large tax bill in the future.

Taxes are complicated. If you’re exercising stock options this year, your tax return will be more complicated than normal, so we recommend working with a tax professional. You can also estimate your stock options-related tax liability with Secfi’s free Stock Option Tax Calculator.

All that said, let’s take a quick look at the tax liabilities you could face when exercising your stock options.

There are three major types of stock options — incentive stock options (ISOs), non-qualified stock options (NSOs) and restricted stock units (RSUs). ISOs and NSOs share some tax similarities, while RSUs are taxed differently.

How ISOs and NSOs are taxed at exercise

ISOs are commonly issued at high-growth startups, while NSOs are a little less common — typically issued to contractors working at startups, or offered as part of an employee stock option purchase plan at publicly traded companies.

That said, both ISOs and NSOs share some tax similarities, with the IRS largely interested in the spread between how much you’ve paid to purchase your stock options, versus their assumed value on the day you purchase them.

For example, let’s say:

  • You exercise 10,000 shares of either ISOs or NSOs, at a strike price of $2.50 per share, paying $25,000 to purchase the shares
  • On the day you exercised the shares, they carried a fair market value (or 409A) of $10 per share, for a total assumed value of $100,000

In this example, when you exercise your shares, you’d report to the IRS three numbers: the $25,000 it cost to purchase the shares, their assumed value of $100,000, and the assumed gain of $75,000.

If you exercise ISOs, you may or may not owe taxes when you exercise, depending on other factors, such as your income and other investments you made that year.

In the United States, ISOs are taxed under the alternative minimum tax system, which can be complicated to understand. If you’d like some help estimating your AMT-related tax liability, check out Secfi’s free Alternative Minimum Tax Calculator.

If you exercise NSOs, you will very likely owe taxes when you exercise, as the assumed gain (in our example, $75,000) is treated as ordinary income.

Remember, with ISOs and NSOs, your employer won’t withhold taxes on your behalf, like they do with cash bonuses or RSUs. That means it’s up to you to accurately calculate and pay for your tax liability.

One more thing to consider: If you leave your company with vested (but unexercised) stock options, you could face a 90-day window to exercise your stock options, or risk losing them forever.

Some companies give employees more than 90 days to exercise their stock options. In that case, if you’re earning ISOs, they’ll automatically convert to NSOs if you fail to exercise them within that initial 90-day window. In general, ISOs have more tax benefits than NSOs.

How RSUs are taxed at exercise

RSUs are commonly issued at startups that are preparing to go public, or at companies that are already publicly traded. Unlike ISOs and NSOs, RSUs are earned (rather than offered for sale), and are treated like a cash bonus with the IRS.

For example, let’s say you’re granted $25,000 worth of RSUs on your one-year work anniversary. When you receive your RSUs, you’d report their value like a cash bonus, and the IRS would tax them as ordinary income.

Oftentimes, companies that issue RSUs will withhold taxes on your behalf, by selling a portion of your shares to cover their related tax burden, in the case of publicly traded shares.

Again, you’ll want to work with a tax professional to make sure that your company withheld the correct amount in taxes from your RSU grant, especially if you earned income elsewhere that year.

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