Are There Tax Advantages to Exercising Your NSOs Early?
Have you ever wondered how to maximize the cash you pocket (and minimize the cash the IRS pockets!) if your employer goes public or gets acquired? If your answer is yes, then you’re in the right place!
Before we dive into our main topic – the tax advantages of exercising your NSOs early – there are a couple of tax concepts you need to understand. By the way, “exercising your NSOs” is just a fancy way of saying that you are buying the shares that your employer promised you.
It’s super important that you-
- Know the IRS taxes your income at different rates depending on the source of the income.
- Understand the difference between your income tax rate and your capital gains tax rate.
Your income tax rate is the percentage of your salary you pay to the IRS. For example, if you earn $175,000 per year, this puts you in the 32% income tax bracket.
Your capital gains tax rate is the percentage of profit you pay to the IRS when you sell stuff that you own. This rate varies based on how long you owned the asset before you sold it.
Owned it one year or less? You pay short-term capital gains. This rate is the same as your income tax rate, so in our example above, 32%.
Owned it for more than a year? You pay your long-term capital gains. This rate is based on your income tax bracket. If you earn $175,000 annually, the long-term capital gains rate is 15%.
Would you prefer to pay a 32% tax rate or a 15% tax rate? We thought so!
Exercise Early, Pay Fewer Taxes
You pay fewer taxes if you exercise your NSOs at least a year ahead of a “liquidity event” or “exit event” – fancy terms that mean an opportunity to sell your shares at a profit.
Imagine the day your company’s IPO has arrived. Maybe some hype, some buzz around you. Your friends and family are waiting to be invited to your yacht. In your head, you’re gleefully calculating the difference between the price you paid for the shares and the IPO selling price.
The profit potential is just….wow! Then you remember you have to pay taxes on that profit. Ugh.
How gleeful are you now?
It depends! Are you paying 32% or 15% on your profit?
Again, it depends! When did you exercise your NSOs?
Let’s Break It Down
Remember that you pay different tax rates on different types of income. If you exercised your NSOs a year or less before the IPO, you pay short-term capital gains on your profit. If you exercised your NSOs more than a year before the IPO, you pay long-term capital gains.
Bottom line? Exercising your NSOs early can mean the difference between paying 32% or 15% on the profit from selling your shares in an exit event.
Are There Risks Associated with Exercising NSOs Early?
While this post is narrowly focused on the tax advantages of exercising early, it’s important to acknowledge the potential downside of exercising your NSOs early. The obvious risk in exercising your NSOs early is the company could stagnate or fail. If the company’s value never increases, you won’t profit. You only profit if you can sell your shares for more than you bought them for. Without the opportunity to sell your shares, you can’t recoup that cash you spent to purchase shares and pay taxes on the purchase, much less make a profit.
A Happy Medium
But what if you’re really confident that your company’s value will increase and will have a successful exit event but you don’t have the cash? Many start-up employees like you don’t have the cash even if they wanted to exercise their NSOs early.
So what’s a startup employee with NSOs to do in this situation?
Believe it or not, there are investors out there that want to buy shares of private companies. And there are companies, like EquityBee, that have figured out a way to meet the cash needs of startup employees like you who want to exercise their NSOs with these investors who want to own shares in private companies like yours.
This is how it typically works: you connect with a company like EquityBee who anonymously offers your NSOs to their accredited investor community. These investors then compete with each other to purchase your options. The winning investor provides the funding to you via Equity Bee so you can exercise your options. You use the funds to exercise your NSOs and become an actual shareholder.
Upon a successful exit event, you and the investor share the profits!