The complete guide to employee stock option taxes

If you’re a startup employee earning stock options, it’s important to understand how your stock options are taxed. If your eyes just glazed over, we get it — taxes aren’t fun. But hear us out: Building your knowledge will give you more power to plan your financial future.

When you understand how stock option taxes work, you can take steps to reduce your tax liability, and potentially make more money when it’s time to sell your shares.

And we’re not talking about the difference of a few extra dollars — being smart about your stock option taxes can translate into a more than 20 percent net gain after your startup exits.

Unfortunately, there’s often a big knowledge gap in this area. Many startup employees aren’t even aware they need to pay taxes when they exercise their stock options.

We’re here to help. In this guide, we cover how incentive stock options (ISOs) and non-qualified stock options (NSOs) are taxed on exercise, as well as when they’re sold. We’ve included information about fair market valuations (also known as 409A valuations), the alternative minimum tax (AMT), and more. Our goal is to help you understand, plan for, and unlock the value of your stock options. Let’s dive in.

The basics of how stock options are taxed

There are two times you’ll likely owe taxes — both federal and state — with stock options: First, when you exercise them, and later when you sell those now-exercised shares.

Most are aware that selling stock is a taxable event, but many are unaware that exercising can also be one. Plus, your decision on when to exercise can also have an impact on the taxes you’ll owe when selling those shares.

Stock option taxes at exercise

Your taxes at exercise depend on the type of stock options you’re earning — ISOs and NSOs are taxed differently.

In the U.S., ISOs are taxed under the alternative minimum tax (AMT) system. Most people are familiar with paying taxes under the income tax system — it’s how your salary is taxed, for example. Most don’t realize it, but everyone also builds up a tax liability each year under the AMT system.

When it comes time to file taxes, you could owe additional taxes under the AMT system, if you manage to build up enough AMT-eligible income. Exercising ISOs adds to your AMT liability, and if you exercise enough ISOs in a single year, you will owe taxes under the AMT system.

And yes, that means you can also choose to exercise a small enough number of ISOs each year to stay under the AMT cap, effectively allowing you to purchase a portion of your stock options without paying upfront taxes.

If you have NSOs, you’re taxed at the ordinary income tax rate at both exercise and sale, with the rate being determined by your income tax bracket. Keep in mind that exercising NSOs could push your income into a higher tax bracket.

With both ISOs and NSOs, your tax obligation at exercise is based on the difference between your strike price and how much the shares are worth, set by the company’s most current fair market valuation (also known as a 409A valuation), or the company’s public share price.

When you exercise ISOs or NSOs, you’re buying shares in the company. Tax authorities consider these shares to have value, based on the company’s 409A valuation on the day you exercise. That value exists, even though most pre-IPO shares are illiquid — meaning no buyers exist for the shares, because the shares are not publicly traded.

If the company’s 409A valuation is higher than your strike price, you’re making an “assumed gain” in the eyes of the IRS. You’re then taxed on that assumed gain.

This tax structure has an important implication: If your company keeps growing, then exercising your employee stock options becomes more expensive over time. The higher the 409A valuation, the larger your assumed gain, and the more tax you’ll owe.

Taxes when selling shares

When you sell shares, your tax bill is largely influenced by how long you’ve held the shares. When you sell shares for more than you paid for them, you’ve created a capital gain. The federal government and many states have specific tax systems for the income generated by capital gains.

Capital gains are either long-term or short-term, based on the amount of time between when you exercised the stock options and when you sold the shares — also known as your holding period.

To qualify for long-term capital gains on ISOs, you’ll need to hold onto your ISOs for at least two years after they were initially granted, and at least one year after you exercised them. If you don’t, any gains you experience at sale will be taxed as short-term capital gains.

It’s a little easier when selling NSOs — you’ll just need to hold onto your NSOs for at least one year after exercising them to qualify for the long-term capital gains rate.

Tax rates for long-term capital gains can be significantly lower than the rates applied to short-term capital gains. Federal long-term capital gains rates range from 0 percent to 20 percent, depending on how much money you earn in the sale, and the other income you earned that year.

Meanwhile, short-term capital gains are taxed according to your income tax bracket, which can be as high as 37 percent at the federal level.

Individual states tax capital gains differently. For example, in California and New York, the tax authorities there make no distinction between long-term and short-term capital gains, and tax all capital gains as ordinary income.

A few states, like Florida and Texas, don’t collect state income taxes, or taxes on capital gains.

It’s worth noting that short-term capital gains on employee stock options could be taxed at a higher rate than your regular income, because the sale of those stock options could push a portion of your income into a higher tax bracket.

ISOs: How they’re taxed

Incentive stock options are a type of stock option popular with pre-IPO startups, because they enjoy more favorable tax treatment than other types of stock options.

ISOs are often (and incorrectly) touted as tax-free at exercise. That’s not necessarily true — depending on how many ISOs you’re exercising, your strike price, and the company’s current 409A valuation, you could potentially owe thousands of dollars, or more, at exercise.

In 2021, the average Secfi client needed $543,000 to exercise their stock options, with roughly $395,000 of that going to state and federal tax authorities.

Most people aren’t familiar with AMT, so it can be a major source of confusion when they go to exercise their stock options and realize they didn’t plan for the AMT, which drives up their cost of exercising significantly.

What is AMT?

The AMT is a parallel tax system in the U.S. meant as a fallback to prevent excessive tax avoidance. It builds up in parallel to your income tax liability, according to a different ruleset.

If you exercise enough ISOs in a single year, you could trigger AMT. People owe AMT on top of their typical income taxes. How much you’ll owe in AMT involves a complicated calculation based on your income, the AMT exemption, and the assumed value of your exercised stock options.

Good news: In later years, you can get back what you pay in AMT in the form of the AMT credit.

The federal government, and several states — notably, California — have an AMT. Every year that you file your tax return, you’re required to calculate your income tax liability as well as your AMT.

The vast majority of Americans will never encounter the AMT. Unfortunately for startup employees, one of the factors that drives up your AMT liability is exercising ISOs.

How to calculate AMT

How much you’ll owe in AMT is based on the difference between your employee stock option’s strike price (how much you pay to buy shares) and the 409A valuation (how much the shares are valued at upon exercise).

Note: With ISOs, there is a tax-free threshold, so you only owe taxes beyond the threshold.

Let’s consider an example. You’re a tech worker in California, earning a six-figure salary at a pre-IPO startup:

• You exercise 15,000 ISOs at a strike price of $3 per share. You’ll pay your company $45,000 (15,000 shares x $3/share)
• When you exercise, the company’s 409A valuation is $35 per share, giving your shares an assumed value of $525,000 (15,000 shares x $35/share valuation)
• You’ll report to the IRS an assumed gain of $480,000 ($525,000 assumed value - $45,000 cost basis)

In this example, you’d pay around 35 percent in combined AMT between California state taxes and federal taxes — so roughly $161,000, after subtracting the tax-free threshold.

That means exercising your shares would cost $206,000 ($45,000 to purchase the shares, and $161,000 in AMT taxes). If you’d like to calculate your AMT tax liability, use Secfi’s free Stock Option Tax Calculator.

How to report AMT when exercising incentive stock options

AMT surprises most people because it’s not automatically taken out or calculated when stock options are exercised. Then, when they go to file their taxes they learn they have an unforeseen cost.

Note that your company will not handle any taxes for you when you exercise ISOs, and that it’s up to you to pay and report any taxes you owe. You’re only paying your company the base cost of exercising options.

After exercising ISOs, you should receive IRS Form 3921 from your employer. This form will include important dates and values needed to properly report taxes when you eventually sell the shares. Save this form.

You and/or your tax professional will use IRS Form 6251 to determine if you’re subject to the federal AMT and calculate associated taxes.

Taxes when selling ISOs

When it’s time to sell your ISOs, there can be significant tax savings if you qualify for long-term capital gains, versus short-term capital gains.

Let’s build on the example above — remember, in this example, you’re a tech worker in California, earning a six-figure salary at a pre-IPO startup:

• You’ve exercised 15,000 ISOs, paying a total of $206,000 in exercise costs and taxes
• When you exercised your shares, they carried a total assumed value of $525,000
• Your startup goes public, and you decide to sell your shares for $150 each, for a total pre-tax value of $2.25 million

If you’ve held your shares for less than a year, you’ll owe an estimated short-term capital gains tax of $831,250. If you hold your shares for more than a year (and more than two years after the ISOs were initially granted), you’ll owe long-term capital gains tax of $500,500.

Depending on your specific numbers, you could end up saving thousands of dollars (and in some cases, hundreds of thousands of dollars) by taking advantage of long-term capital gains. Check out Secfi’s free Stock Option Tax Calculator to begin to build an estimate of your stock option tax liability.

How to report taxes when selling ISOs

When you sell your shares, you’ll receive an IRS Form 1099-B from the brokerage firm that handled the stock sale. This form reports any capital gains or losses resulting from the transaction, which you’ll use to report on Schedule D of your IRS Form 1040.

How to minimize taxes on ISOs

If you’re earning ISOs, there are three main strategies to minimize your tax liability: Exercising your ISOs early, exercising a small number of ISOs each year, and performing a cashless exercise.

Exercising your ISOs early starts the clock on long-term capital gains

Some startups allow their employees to exercise some or all of their ISOs before they vest, giving employees the chance to pay little or no AMT. This is called “early exercising.”

Buying shares in certain early-stage startups can qualify you for the Qualified Small Business Stock (QSBS), a special tax exemption that allows people to sell millions of dollars worth of shares tax-free if the company is small enough, and the person holds onto their shares for long enough.

The major risk of early exercise is that the value of your shares could decline, or collapse entirely, while you’re waiting to sell your ISOs. Exercising pre-IPO shares is inherently riskier than waiting until an exit to exercise.

Exercising a small number of ISOs each year to stay under the AMT threshold

Startup employees earning ISOs can always decide to exercise (i.e. purchase) just enough ISOs each year to remain under the AMT threshold. This strategy works best when an ISO’s strike price and 409A valuation is still relatively near one another in value. If you’d like to explore this strategy, check out Secfi’s free AMT Calculator.

Performing a cashless exercise to reduce upfront taxes

Cashless exercises are the most common strategy that people use with ISOs, because many can’t afford to exercise before an exit event. Cashless exercises require no upfront cash, and as a result, carry the least amount of risk — you’re able to see exactly how much it will cost to exercise your ISOs, and the exit price.

In a cashless exercise, you sell some or all of your shares, and then use the resulting funds to cover any exercise costs and associated taxes, in what the IRS effectively treats as a single transaction.

There are two major drawbacks to a cashless exercise: One, you’ll pay short-term capital gains on any gains, and two, you may need to stay employed until the exit event occurs, which could be many years in the future.

Still, for people who can’t afford to exercise their shares ahead of the exit event, a cashless exercise allows them to avoid upfront exercise taxes, while reducing their risk.

NSOs: How they’re taxed

Non-qualified stock options (NSOs) don’t enjoy the same preferential tax treatment that ISOs do. At startups, they’re typically issued to contractors, vendors, and executives.

In some cases, they’re granted to former employees who leave the company, and fail to exercise their ISOs inside the company’s 90-day post-termination stock option exercise window. In those cases, unexercised ISOs get automatically converted into NSOs.

Like ISOs, NSOs are taxed when you exercise them, and when you eventually sell them.

Taxes when exercising NSOs

How much you’ll owe in taxes at exercise is based on the difference between your stock option’s strike price (how much you pay to buy shares) and the company’s 409A valuation (how much the shares are valued at upon exercise).

Let’s consider an example. You’re a tech worker in California, earning six figures at a pre-IPO startup:

• You exercise 15,000 NSOs at a strike price of $3 per share. You’ll pay the company $45,000 to exercise the shares (15,000 shares x $3/share)
• When you exercise, the company’s 409A valuation is $35 per share, giving your shares an assumed value of $525,000 (15,000 shares x $35/share valuation)
• You’ll report to the IRS an assumed gain of $480,000 ($525,000 assumed value - $45,000 cost basis)

NSOs are taxed at ordinary income tax rates, so in this example, you’d pay around 46 percent in combined California state taxes and federal taxes — roughly $221,000. Note: Your tax rate at exercise is affected by your other income.

That means exercising your NSOs would cost $266,000 ($45,000 to purchase the shares, and $221,000 in taxes). If you’d like to calculate your NSO taxes, use Secfi’s free Stock Option Tax Calculator.

Tax authorities treat NSOs as if you were getting a cash bonus, which means exercising NSOs could push your income taxes into a new, higher bracket.

How to report taxes when exercising NSOs

Exercising NSOs triggers a tax withholding requirement at your company — just like if they were paying out a cash bonus. The company collects payment from you to submit taxes to the government on your behalf.

When you exercise NSOs, your company will send you an estimate of the withholding tax that they are required to send to the government. You’ll need to pay the company your exercise costs, as well as the estimated tax withholding, to exercise your NSOs.

Note: Companies are only legally required to withhold the minimum amount of taxes when you exercise NSOs. You’ll want to double-check that amount with the help of a tax professional, to make sure you don’t inadvertently owe a surprise tax bill when it comes time to file.

When you file your tax return, you’ll calculate your actual tax bill against what your company withheld. If your withholding is greater than your actual tax bill, you’ll get a return of cash due to overpayment. If your withholding is smaller than your actual tax bill, you’ll owe additional taxes.

Ultimately, it’s your responsibility to pay the correct amount of taxes when you exercise your NSOs. You could be required to make estimated tax payments throughout the year to supplement your employer’s withholding. Make sure you’re paying your taxes on time to avoid future penalties.

Taxes when selling NSOs

As we covered earlier, you’ll owe taxes when you exercise (i.e. purchase) your NSOs, and you’ll owe additional taxes if the shares continue to grow in value, and you eventually sell them at a profit.

When you sell your NSOs, you create either a capital gain, or a capital loss, depending on whether you make money or lose money in the transaction.

If you experience a capital gain, you’ll owe taxes based on how long you’ve held the shares — long-term capital gains if you’ve held the shares for at least one year after exercising them, or short-term capital gains if you’ve held the shares for less than a year.

Note: States tax capital gains at different rates. For example, in California and New York, state tax authorities make no distinction between short-term capital gains and long-term capital gains — all capital gains are taxed as ordinary income. Other states, like Texas and Florida, do not tax capital gains.

How to report taxes when selling NSOs

When you sell your shares, you’ll receive an IRS Form 1099-B from the brokerage firm that handled the stock sale. This form reports any capital gains or losses resulting from the transaction, which you’ll use to report on Schedule D of your IRS Form 1040.

How to minimize taxes on NSOs

There are two ways to minimize taxes when buying and selling NSOs: Exercising now to start the clock on long-term capital gains, and performing a cashless exercise to reduce upfront taxes.

Exercising NSOs now to start the clock on long-term capital gains

If you’re earning NSOs and want to take advantage of the long-term capital gains tax rate, you’ll need to exercise your stock options to start the clock on that lower tax rate. To qualify, you’ll need to hold onto your exercised shares for at least one year before selling them.

The major risk is that the value of your shares could decline, or collapse entirely, while you’re waiting to sell your NSOs.

Performing a cashless exercise to reduce upfront taxes

Most people who earn NSOs perform what’s known as a cashless exercise, where they sell some or all of their shares, and use the money to pay exercise costs, and any associated taxes.

The major benefits to a cashless exercise are twofold: One, you reduce your risk because you know how much your shares will cost, and how much they’re worth, and two, you don’t have to spend any upfront money of your own.

The drawbacks are also twofold: One, you’ll pay the highest possible combined tax rate on the transaction, lowering your total gains, and two, you’ll likely need to stay in your job until the exit to perform a cashless exercise.

Additional resources

Stock Option Tax Calculator
Stock Option Exit Calculator
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