For startup employees with stock options, taxes are a tricky topic. You can owe taxes several times throughout your stock options journey — including when you exercise your options and when you sell your shares. And how much you owe is determined by multiple factors. Plus, you’ll likely get a tax bill from the IRS and your state tax authority.
There’s a lot to digest but we’re here to help. In this guide, we summarize how stock options are taxed in California, covering the implications for ISOs, NSOs and RSUs.
- When you exercise ISOs, you may owe California taxes if you trigger the AMT (alternative minimum tax).
- When you exercise NSOs, you pay California income tax on the spread between your strike price and the current 409A valuation (or fair market value).
- With RSUs, you’re subject to California income tax when the shares are delivered to you.
- When you sell your shares, any capital gains are taxed as ordinary income in California.
How are ISOs taxed in California?
When early-stage startups give you equity compensation, it’s usually in the form of incentive stock options (ISOs). ISOs enjoy more favorable tax treatment than other types of stock options.
What happens when ISOs are granted and when they vest? ISOs aren’t taxed when they’re granted nor when they vest.
What happens when you exercise ISOs? You won’t owe any California taxes at exercise unless the state’s alternative minimum tax (AMT) is triggered.
Here’s how the AMT works:
- Every year you file a tax return, you’re required to calculate your regular tax liability as well as your AMT.
- The AMT builds up in parallel to your regular tax liability, according to a different ruleset.
- In the end, you pay either the AMT or your regular tax bill — whichever is highest.
Exercising enough ISOs may put your AMT above your regular tax liability, forcing you to pay the additional tax.
If you’re curious whether exercising your ISOs would trigger the AMT, check out our free Stock Option Tax Calculator. Enter your details and get a breakdown of your total exercise costs, including state and federal AMT.
One way to avoid triggering the California AMT is by finding your so-called AMT crossover point: the gap left between your current income and the amount that would trigger the AMT. Using your strike price and the current 409A valuation, you can calculate how many options you can exercise this tax year right before you hit the crossover point and have to pay the AMT.
One of Secfi’s equity strategists would be happy to help you discuss the pros and cons of implementing this strategy. You can also consult with your tax professional and/or financial advisor.
What happens when you sell your shares? Capital gains and losses are created when you sell an asset for more or less than you spent to buy it. The federal government has a tax system specifically for capital gains and losses. However, that’s not the case in California, where all capital gains are taxed as ordinary income. The exact rate will depend on your filing status and income.
How are NSOs taxed in California?
Non-qualified stock options (NSOs) are a type of options that don’t “qualify” for the same favorable tax treatment as ISOs.
What happens when NSOs are granted and when they vest? NSOs aren’t taxed when they’re granted nor when they vest.
What happens when you exercise NSOs? At exercise, you pay California income tax on the spread between your strike price and the current 409A valuation. The exact rate will depend on your filing status and income.
When you notify your company that you want to exercise NSOs, your company will send you an estimate of the California taxes owed. This is called a withholding estimate.
Keep in mind that this withholding estimate is different from the withholding you see on your regular pay stub, where your company holds back money from your wages to cover taxes. With stock options, the withholding amount represents what you must pay to the company in order to exercise your NSOs.
A common misconception is that your company’s withholding calculation equals your final tax bill. This is not true. Your company will only withhold what it is legally required to. Often, this means the withholding tax you pay to your employer to exercise your NSOs is less than your final tax bill.
As such, you may need to make estimated tax payments throughout the year to supplement the withholding. Make sure you are paying your taxes on time to avoid penalties when you file your tax return.
What happens when you sell your shares? Similar to ISOs, gains are taxed at California income tax rates. The exact rate will depend on your filing status and income.
How are RSUs taxed in California?
Restricted stock units (RSUs) are a way your employer can grant you company shares at a later time.
Successful late-stage companies with high valuations offer RSUs as a recruiting and retention tool. At this stage, offering stock options can be less compelling to potential new hires because the strike price is high.
What happens when RSUs are granted? RSUs aren’t taxed when they’re granted.
How are RSUs taxed at vesting and issuance? You’re subject to California taxes when the shares are delivered to you. The timing of delivery is determined by your vesting scheme:
- Double trigger vesting - In most cases, the vesting scheme will have both a time trigger and an exit trigger. This is called double trigger vesting. Shares vest according to schedule while you’re working at the company (time trigger) and are issued to you once there is an exit (exit trigger).
If your RSUs vest according to a double trigger scheme, there is no tax event upon vesting. You incur taxes when then the shares are issued to you.
- Single trigger vesting - If your RSUs are issued according to a vesting scheme with only the timing component, you’ll be taxed as soon as the shares vest.
California taxes are calculated as if the company has just given you a cash bonus equivalent to the value of the shares. The amount is reported on your paystub and W2 and taxed as compensation income.
Your company is required to withhold a certain amount for taxes, but your company’s withholding won’t necessarily equal your final California tax bill. You may be responsible for making estimated tax payments throughout the year to supplement the withholding.
What happens when you sell your shares? Similar to ISOs and NSOs, gains are taxed at California income tax rates. The exact rate will depend on your filing status and income.
Selling shares after you leave California
There are several key milestones for startup employees with stock options, including the dates when options are granted, vested and exercised, as well as when the shares are sold. It’s entirely possible that you might not live in California when each one of these milestones occurs.
For example, you could exercise your ISOs while you’re living in California then move out of state a few months later and sell your shares. Or perhaps you move out of California after your RSUs are granted but before they vest.
What does this mean for your California taxes?
In cases like this, there isn’t a one-size-fits-all solution. It’s best to consult a tax professional who can help you navigate your individual situation.
Looking for more information?
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