November 3, 2020
My Snowflake case study sparked quite the debate on Twitter last week. It got a lot of startup folks thinking about their own stock options (which is awesome!). And with Palantir and Asana going public this week, even more people have this top of mind.
One common response was: wait – you're telling me I owe tax on exercise?
The answer: yes – in almost all cases.
This is still unknown to most startup employees and probably the number one topic I discuss with clients.
Exercise tax bills can become pretty extreme. Sometimes many multiples more 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:
The amount you owe is unbounded. Theoretically, there's no limit to how high it can get.
It seems weird, right? I agree! But it's the way our tax system is built. The logic is as follows:
When you exercise stock options, you're buying shares. The government considers these to have value: whatever the 409A valuation (or fair market value) is on the day you exercise. But since you only have to pay the strike price, you're making a "profit". That (phantom) profit is what you're taxed on 👻
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:
The rate you're taxed at 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. That's why your tax bill can grow endlessly.
Yes, they're supposed to.
The "exception" to this is when you trigger that AMT. In practice, this almost always happens though, so it's not really an exception… And since most people don't know about the AMT, that's a major source of confusion.
Before exercising, you'll want to know the tax bill you're about to trigger. By hand that calculation gets messy: the AMT is complicated, and it also depends on your income, tax brackets, etc.
Instead, there's an online calculator that crunches the numbers for you and it's free.
There you go.
If you feel like geeking out fiscally (not judging – I'm just like you 🤓) you'll also be able to see the full tax breakdown, or explore strategies 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:
1. When the 409A valuation is equal to the strike price of your stock options
Or when it's lower. This way you're not making a "phantom profit" so there's nothing to be taxed on. (Applies to both ISOs and NSOs.)
2. When you exercise just a small amount of ISOs
This way your "phantom profit" is low enough to not trigger the AMT. (Only applies to ISOs.)
In some cases, you can use the above exceptions to your advantage and avoid having to pay taxes:
1. Early exercising (ISOs & NSOs)
Some companies allow you to early exercise your options. This means you can exercise your stock options before they are vested. 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 won't owe taxes.
If you early exercise, make sure to file an 83(b) election.
2. Staying below the AMT threshold (ISOs only)
If you exercise 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. 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 check to the government.
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. (Actually 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 ↘️