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I am working at a startup in California, USA and I was given some options of the type ISO, with a four year vesting period. Very soon, I will complete one year and I would like to execute 1/4th of the shares. I have a confusion - how much tax I need to pay to IRS next year?

Let me explain with some numbers

  • Country: USA
  • State: California
  • Options Type: ISO
  • Total options allotted: 4000
  • Strike Price: $1

After one year (19th March 2019)

  • Vested options: 1000
  • Strike Price: $1
  • Current Price: $11
  • Bought all 1000 options.

In 2020

  • How much tax I need to pay on these options

One friend said

  • As the current price (at the time of executing the options on 19th March, 2019) is $11, I got a paper gain of ($11 - $1) * 1000 = $10,000
  • So, I need to pay taxes on $10,000
  • Along with this I also need to pay some interest on the tax for the period from 19th March, 2019 to 31st December, 2019. As per my friend, IRS may ask me that if I know that much tax I need to pay, why I waited till the next year to pay those taxes.

Another friend said

  • I don't need to pay any taxes. I need to pay this only when I get some money.
  • One case is: if the company goes to IPO or
  • Another case is: if some other company buys our company in the future

Help me understand how much taxes I need to pay, if any.

Update: Added missing country and options type in the above description.

  • What country are you in? – D Stanley Feb 9 at 17:22
  • Since you tagged this IRS I assume you're in the US (cc @DStanley). Are the options NQ or ISO? – Kevin Feb 9 at 19:38
  • @Kevin, USA, California. Options type: ISO. – Sasidhar Vanga Feb 9 at 21:32
  • Then yeah, you'll want to follow the second half of Hilmar's answer. I suggest getting an accountant to help, the rules are rather complex. – Kevin Feb 9 at 23:03
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Assuming that is in the US, this depends whether these are ISO (Incentive Stock Options) or NQ (Non-qualifying) stock options.

NQ Options:

The paper gain (or spread) is taxed as regular income. So yes, you need to pay taxes on the exercise in the tax year 2019. If it's a lot you may need to pay estimate taxes earlier or risk an underpayment penalty. You need to run the exact numbers to find out.

When you sell the share (in any year) the difference between the current price and the $11 price at exercise is taxable as either long or short term capital gain (or loss). "Long Term" will apply if you sell the shares more than a year after exercising the options

ISO Options

In 2019, the spread (paper gain), is NOT taxable under standard tax rules but it is counted as compensation income for AMT calculation. You may or may not have to pay AMT on the exercise, depending on how the rest of your tax picture looks like.

When you sell the stock later, again two different rules apply: Under regular tax rules the entire difference between sell price and strike price (NOT exercise price) is taxable as capital gain or loss. For AMT rules, the difference between sell and exercise price (NOT strike price) is taxable as capital gain or loss.

In any year you pay the larger tax of regular and AMT rules. This often leads to double taxation of ISO options when you hold them: you pay AMT in the year you exercise and you pay regular capital gains tax in the year you sell. To compensate the IRS has come up with the concept of "AMT Credit" which may or may not allow you to recover the double taxes.

Overall this horribly complicated and an atrocious set of tax law. It's strongly recommended to consult a tax professional, but you need to find the right one: I've certainly met tax "experts" that did not fully understand how this works and how to optimize your strategy.

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