Exercising Startup Stock Options and Tax Implications (2018)

Stock Options at an early startup sucks, until it doesn’t.  Basically until the company goes public (IPO), sells to another company, or grows big enough to know it’s not going to fail, these stock options are a costly gamble.  Purchasing my stocks and paying the taxes cost me about $33k!  Since these options were part of my compensation package, it’s really hard to leave them on the table though.  I’ve got too much FOMO to not buy them!  Here’s the story of my 2nd options exercise and how it affected my taxes.

Startup Stock Options?

Most young employees who just joined a startup don’t really understand the how stock options work.  I know I didn’t know when I first started.  I was just offered X stock options at Y price.  I was more concerned about base salary at the time as that was a number I could understand and compare to a previous job.

This article is about what happens when you exercise your options and does not explain an intro to startup stock options. Read about Understanding Your Startup Stock Options Compensation for understand your options.  My opinion on stock options as an early employee is a bit jaded, but that’s how the game is played.  If you want a bigger piece of the pie, I guess you just have to start your own business.

Exercising Stock Options

When I left a former company as an early employee, I was left with a decision to exercise or not to exercise.  The company was still very young, but doing well and since these options were part of my compensation, I felt I needed to exercise them at any cost!  Here’s how much it cost me.

I had 175,000 options with a strike price at $0.10.  That means for me to purchase the stock at my special price of $0.10 it cost me 175000 * $0.10 = $17,500 up front.  So I wrote a check for $17,500 which was the 2nd largest check I had written at that time!  But that’s not the end of the costs!  Now I have to report this on my taxes and I have quite a lot to pay there as well.

How Much Are the Taxes?

So I was able to purchase my stock options at a reduced price ($0.10), but how much are they worth?  At the time I exercised, the latest 409A appraisal for the company came in at $0.27 a share. This is used as the Fair Market Value (FMV) for the company and must be reported on your taxes.  So if the FMV is $0.27 and I purchased for $0.10, then the difference of $0.17 is gained for every share I purchased.  So I gained $0.17 * 175,000 shares = $29,750 when I chose to exercise my options.  This gain is not taxed as income, but it must be reported for Alternative Minimum Tax (AMT) calculations.

What the hell is AMT?

Alternative Minimum Tax is a different way of calculating your taxes and was implemented to prevent rich people from escaping their taxes by exploiting the regular tax code with excessive deductions and such. For most people they calculate their taxes using the regular tax code by totaling their income (their pay, capital gains, dividends) minus their deductions and you pay on this total amount based on the normal Tax Brackets (10%, 15%, 25%, 28%…).  With AMT calculations, it takes away most itemized deductions, gives you a flat deduction, and multiples this by a tax amount of 26% for amounts less than $186,300 and 28% for higher.  If the AMT calculation is higher than your regular tax calculation, then you pay the additional difference of (AMT calculation – Regular calculation).  For most people, the AMT calculation is less than the Regular calculation and thus you owe no AMT. All is not lost though, as you do receive a AMT tax credit for future years.

Unfortunately, even though i’m not rich, the exercise of these options is factored into the AMT calculations.  To make matters worse, I received my 3921 form from the company at tax time, I found out the Fair Market Value was $0.50 rather than $0.27 I initially thought.  That means my gain was $0.40 * 1750000 = $70000 which is calculated into AMT

Here’s how the taxes come out…

Regular Tax calculation $14,917
AMT calculation $30,357
AMT amount $30,357 – $14,917 = $15,440
Total Tax Owed $14,917  + $15,440 = $30,357
AMT Credit for future years $15,440

So I ended up paying a total of $30,357, an extra of $15,440 in taxes then I would normally have paid if there is was no exercise that year.  That on top of the $17,500 I paid to exercise my options!

So that year, I had a reported income of $77k (I took a paycut for these options), paid 30k in taxes and $17.5k for my stocks leaving me about $39.5k to live off of!  Thanks US tax code for screwing me over. This does not even include State AMT which you may be imposed on you as well!  So my stock options cost me a total of $32,940. >_<

How AMT Tax Credits Work

So I paid that extra $15,440 in AMT, but this does go in as a credit for future years.  So the AMT is a fluke year for me since I don’t exercise options every year.  That means normally my Regular tax calculation will be higher than my AMT calculation.  In the next year if my regular tax calculation comes out to $15k and my AMT calculation comes out to $10k, then I can apply up to $5k (15k – 10k) of my $15,440 worth of credit. That means I will only have to pay $10k tax that year since I can apply $5k worth of AMT credit for a total of $15k taxes paid!

Credit Carryover

If i used $5k worth of credit I can then carryover $10,440 worth of credit for future years, eventually getting it back. Credits don’t expire, but do not apply on years where your AMT calculation is higher than your Regular Income for instance if you exercise more options in the future or do something that raises your AMT.

Selling Your Stocks

For private companies you generally cannot sell your shares especially at a market value. So you’re just kinda left in limbo with a bunch of lotto tickets.  You are done with taxes though! Just kidding. You’ll have to do a bunch more tax calculation when you sell those shares and as they will be taxed as capital gains.  But we’ll let future me worry about that if that even happens.  At least i’ll have liquid money from the stock to pay off these taxes!

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