April 6, 2021
One common response was: wait – you're telling me I owe tax when I exercise my stock options?
The answer: yes—in almost all cases.
This is still unknown to most startup employees. And it's probably the number one topic I discuss with clients.
Here's the TL;DR
Note: If exercising your options creates a tax bill you can’t afford, Secfi can help cover the costs. Learn more here.
Exercise tax bills can become pretty extreme. Then can get as much as 10X higher than the strike price you pay to actually buy the shares.
Some examples of people I know:
Engineer at Doordash:
Strategy Analyst at Snowflake:
Secfi's own Wouter Witvoet at his previous company:
Taxes can get so high that exercising becomes virtually impossible for many. Theoretically, there's no limit to how high they can get.
Which brings up the question:
Why do I have to pay taxes when I'm not making any money?
It’s weird, right? But it's the way our tax system is built.
Let’s get into the details...
When you exercise stock options, you're buying shares.
The government considers these shares to have value. That value is based on whatever the 409A valuation (or fair market value) is on the day you exercise.
If the 409A is higher than your strike price, you're making a "profit" in the eyes of the IRS.
That (phantom) profit is what you're taxed on 👻
Here's an example:
Say you have 1,000 options at a strike price of $2.50, and the current 409A valuation is $10.
When you exercise you’ll pay:
How much you're taxed depends on whether you have NSOs or ISOs:
There's no limit to the 409A valuation of a company, just like any stock price. The more successful your company becomes, the higher the 409A valuation gets.
And that's why your tax bill can grow endlessly.
Yes, they're supposed to.
The "exception" to this is when you trigger the AMT. But in practice this almost always happens.
So it's not really an exception. And since most people don't know about the AMT, it's a major source of confusion.
Before exercising, you'll want to know the tax bill you're about to trigger. But by hand that calculation gets messy. The AMT is complicated, and it depends on your income, tax brackets, etc.
To make it as easy as possible, we've built an online calculator that crunches the numbers for you (and it's free).
There you go.
If you feel like geeking out fiscally (no judgements here—I'm just like you 🤓) you'll also be able to see the full tax breakdown and explore how to minimize taxes.
To use the calculator, sign up here.
As the title of this post says: you're going to have to pay taxes... Probably.
There are two exceptions to the rule:
When that happens, you're not making a "phantom profit." So there's nothing to be taxed on.
(This applies to both ISOs and NSOs.)
This way your "phantom profit" is low enough to not trigger the AMT. (But this only applies to ISOs.)
In some cases, you can use the above exceptions to your advantage and avoid having to pay taxes.
Some companies allow you to early exercise your options.
This means you can exercise your stock options before they fully vest.
Because the strike price of your stock options is usually set to the 409A valuation at the time you're granted the options, early exercising lets you exercise before the 409A valuation goes up. That way you're not making a phantom profit—and you won't owe any taxes.
⚠️ Warning: If you early exercise, make sure to file an 83(b) election. Otherwise you might end up with an unexpected tax bill down the road.
If you exercise your ISOs, you'll pay alternative minimum tax (AMT)—but only if you go above a certain threshold.
This means that, every year, you can exercise a number of ISOs tax-free.
The maximum number of tax-free ISOs depends on your tax situation (but it comes with its own downsides).
We built a (free) calculator that runs the numbers for you:
Create an account here to use the calculator.
Out of the hundreds of startup employees I've advised, more than two-thirds didn't know that exercising stock options also means writing a (big) check to the government.
And it's not surprising that this isn't well-known:
But it is a problem. Especially when employees discover the size of their tax liability after exercising and there’s no way back. (This really happens.)
I posted this explanation to try and clear the confusion for good. Hope it helps spread the word 🤞.
Any questions or comments? Hit me up for a quick chat in the bottom-right ↘️
Still working on this one.
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