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How to calculate taxes on underwater employee stock options

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Editor’s note: A version of this question originally appeared on Reddit.

I will preface this by saying that I will definitely seek out professional help for my specific case, but I imagine this kind of thing happens often enough that people know what generally happens.

I exercised my stock options in 2021. The stocks had a strike price of $X and a 409A valuation of $Y, and I expected to pay taxes on the spread between $X and $Y.

The company went public at the end of 2021, and the value of the stocks ended up being 0.9x of $Y. Do I still owe taxes on the spread between $X and $Y, or will I owe taxes on the lesser spread of $X and 0.9x of $Y?

If I owe taxes on the larger spread, can I consider the difference between $Y and 0.9x $Y as a capital loss?

- Anonymous


Dear Anonymous,

First, you’re correct — a lot of people experienced similar scenarios when their companies went public in 2021.

It’s undoubtedly been a challenging IPO market. In November, analysts estimated that half of the world’s largest IPOs were trading below their listing price.

That can be a problem for people who exercise their stock options just ahead of an IPO, especially if they find themselves underwater once the company goes public.

Long answer short: In the U.S., people who exercise stock options owe taxes at the time of exercise, and then owe taxes again once they sell. For you, it would be two separate transactions, and you’d record a capital loss if you were to sell today.

Let’s drop in some hypothetical numbers so we don’t have to keep using $X and $Y. Let’s say your strike price was $20 per share, and your 409A valuation (also known as fair market value) at exercise was $100 per share.

If you exercised 1,000 shares, you would have paid a base exercise cost of $20,000 (1,000 shares x $20/share), and potentially owed taxes on the assumed gain of $80,000 (1,000 shares x $100/share 409A valuation - $20,000). If you’d like to estimate your taxes at exercise, check out Secfi’s Stock Option Tax Calculator.

Once the company went public, shares began trading at $90 per share. Hypothetically, if you were to sell all your shares, you’d report a capital loss of $10,000 ($90,000 stock sale - $100,000 equity base value).

These two transactions are treated as distinct events to the IRS — you’d potentially owe taxes at exercise, and separately report capital gains or losses once you sell the stock.

Additionally, if you exercised incentive stock options (ISOs), you might be eligible for the AMT credit, depending on your specific situation. I’d encourage you to talk to a CPA, who can review your specific numbers more closely.

- Vieje Piauwasdy, Senior Director of Equity Strategy, Secfi

Do you have a question about your stock options? Email us at ask@secfi.com

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