What are the tax implications of exercising options early?

Question

Say you have the following situation:

• You have pre-IPO stock options
• Half of the options have vested, the other half will vest over the next 2 years
• Your strike price is S
• The fair market value of the stock is now F, where F > S
• It seems likely the company will go public in a year or so
• I'm in the US

What are the tax implications of exercising my options early? I've heard something about some sort of tax (AMT?) on the difference between F and S. However, I've also heard you need to hold the stock for a year to avoid some sort of capital gains tax, and exercising early gets the clock ticking earlier. What is the math here? How can I tell if it's worth it?

Answer 1

Despite a fair number of views, no one besides @mbhunter answered, so I'll gather the findings of my own research here. Hopefully, this will help others in similar situations. If you spot any errors, please let me know!

1. Exercising your options and taxes: If the strike price for your stock is S and the current fair market value is F, then the difference (F - S) is subject to taxes, even if you don't actually sell the stock and realize that profit.
2. Non-qualified stock options: are subject to income taxes, which roughly means you take the "profit" from (1) and add it to your income, as if it was part of your salary. This means it gets taxed at whatever tax bracket your salary + profit end up in, usually in the 10-35% range.
3. ISO stock options: are not subject to income taxes, but they do get counted when calculating AMT. Although most people aren't typically subject to AMT, if you make enough profit from (1), you may be. Not sure what the rate is for AMT, but seems to be around 25%.
4. AMT calculation: fill out form 6251 or use software such as TurboTax (it takes just a couple minutes using the latter).
5. Selling your options: if you sell your options at price P, the difference between (P - F) also has tax implications. If (P - F) is negative - that is, you lost money - you can write it off. I believe the maximum write off is $3k per year. If (P-F) is positive - that is, you made a profit - it gets taxed.
6. Short term capital gains tax: if you sell your options less than one year after exercising, the profit is subject to short term capital gains tax. Similar to (2), this roughly means the profit is tacked onto your income as if it was part of your salary and depending on what bracket you end up in, gets taxed at 10-35%.
7. Long term capital gains tax: if you sell your options more than one year after exercising (and two years after the options were granted), the profits are subject to long term capital gains tax, which is typically 15%.
8. Exercising options early: some companies allow you to exercise all your options early - that is, before they actually vest (though you still won't be able to actually sell them until they vest).
9. Advantages of exercising options early: as soon as you exercise, the "clock starts ticking" for when you get into long term capital gains territory and consequently, pay far less taxes when you sell your options. Moreover, if the fair market value is increasing, exercising sooner minimizes (F - S) and consequently, minimizes the "profit" that gets taxed at the relatively high rates of income/AMT taxes as described in (1) and (2). Exercising when F == S and waiting at least one year to sell your options keeps taxes to an absolute minimum.
10. Disadvantages of exercising options early: to exercise your options, you must pay (S * N) + (F - S)(N)(income tax or AMT rate) where S = strike price, F = fair market value, N = number of shares. This may be a lot of money up front, especially given that you might not actually be able to sell these options for a long time. Moreover, by the time you can sell, it's possible that the stock tanks - or perhaps the company doesn't go public in the first place - at which point you're out a lot of money.

Answer 2

The difference is whether your options qualify as incentive stock options (ISOs), or whether they are non-qualifying options.

If your options meet all of the criteria for being ISOs (see here), then (a) you are not taxed when you exercise the options. You treat the sale of the underlying stock as a long term capital gain, with the basis being the exercise price (S).

There is something about the alternative minimum tax (AMT) as they pertain to these kinds of options. Calculating your AMT basically means that your ISOs are treated as non-qualifying options. So if your exercise bumps you into AMT territory, too bad, so sad.

If you exercise earlier, you do get a clock ticking, as you put it, because one of the caveats of having your options qualify as ISOs is that you hold the underlying stock (a) at least two years after you were granted the options and (b) at least one year after you exercise the options.