Maximize Your Returns: A Tech Worker's Guide to Exercising Equity & Optimizing Taxes
Maximize Your Returns: A Tech Worker's Guide to Exercising Equity & Optimizing Taxes
Part 2 of 3 in our month long series on Employee Equity
“It was at that moment, staring at a bank account balance of zero, I was dead broke, but also a paper millionaire.”
-Rich / Poor Guy I once worked with
Welcome back to our month long series on employee equity:
Part 1: What’s a 409a Valuation (LAST WEEK)
Part 2: A Tech Worker's Guide to Exercising Equity & Optimizing Taxes (TODAY!)
Part 3: Getting RICH off Secondary Transactions (NEXT WEEK!)
Incentive stock options are a form of employee compensation. They can make tech workers fantastically wealthy if the company goes parabolic. However, they require employees to take a financial leap of faith, breaking out their checkbooks to both exercise their options and sometimes pay taxes on an asset which lacks a liquid market to “sell and cover” (a term we’ll cover below).
Here’s what we’ll get smarter on today for all of you folks out there who are compensated through equity in some form or another:
Tax Treatment for Different Forms of Equity
ISOs
What is Alternative Minimum tax?
Selling your ISOs
NSOs
RSUs
Early Exercise
As a reminder, paid readers get access to our compensation and equity benchmarking tool. Figure out how much equity you deserve!
Tax Treatment for Different Forms of Equity
1. Incentive Stock Options (ISOs)
ISOs are the most common form of equity for full-time employees working at earlier stage startups (I’m talking pre series D / sub $1 billion and valuation / fewer than 500 people).
NSOs are generally reserved for advisors and consultants, while RSUs typically come into play when the company’s size and valuation balloons.
ISOs are unique because they are just that - Options to buy a stake in a company. You get to purchase your shares (or exercise your option) at a predetermined price. And you can pick when you make that jump.
If you leave your company, and are past your 1 year cliff (which is typical for most equity grants), then you have up to 90 days post termination to exercise your options. If you need longer, you can ask your company to convert them to NSOs, but there’s no guarantee your company will play nice and help you out.
ISOs are also more favorable to NSOs because, up to a certain level, you are exempt from having to pay taxes at the time of exercise.
In addition, if you hold the shares for at least one year after the exercise date and two years after the grant date before selling, any profit is treated as long-term capital gains, which are taxed at a lower rate than ordinary income.
The fastest scenario (excluding any early exercise shenanigans) in which you qualify for long term capital gains would be if you work for one full year to hit your cliff, vesting 25%, and immediately exercise…
Then you sit on them for one more full year before selling.
So the clock ran for two years total.
However, past a certain point, you are subject to Alternatives Minimum Tax (AMT), which is the taxable difference between your strike price and the company’s latest 409a at time of exercise.