The Startup Employee’s Guide to Options and Taxes: Glossary
Navigating the United States’ tax system is rarely simple, but it can be especially complex when it comes to startups and stock options.
Stock options – which give employees the right to buy company shares at a later date – are common in startup culture. They help early stage, limited budget startups compete with the salaries and benefits packages offered by more established companies. Stock options also give employees the opportunity to own parts of the companies they’ve helped build.
Even though stock options are a significant part of many compensation packages (and are therefore earnings that you’ve worked hard for), the red tape and unclear tax expectations keep far too many startup employees from accessing these potentially life changing financial opportunities.
We get it: you’re a startup employee, not a tax expert.
Throughout the following seven blog posts, this series will unravel and decipher the tax implications of exercising your incentive (ISO) and non-qualified (NSO) stock options. Before you read further, we recommend revisiting your own grant letter, which contains critical information about your stock options. This will help you get the most out of this series.
If your stock options meet certain criteria, there’s even a chance that you’ll pay $0 in federal taxes… but more on that later.
As the majority of startup employees receive ISOs and NSOs, we will focus this series on NSOs and ISOs only. We will not cover the details of stock appreciation rights (SARs), employee stock ownership plans (ESOP), or restricted stock units (RSUs).
Before we get started with the details, though, let’s dive into a glossary filled with many commonly used terms related to stock options and taxes.
Alternative Minimum Tax (AMT)
The purpose of AMT is to make sure that certain taxpayers are responsible for paying at least a minimum amount of income tax. To calculate your AMT adjustment for your ISOs, take the difference between the fair market value (FMV) and the grant price for your options. The resulting number is your AMT’s spread; this amount, multiplied by the number of options you are exercising, is treated as AMT income and can increase your tax liability.
Capital Gains Tax
The capital gains tax applies to profits or losses caused by the sale of an investment and depends on that investment’s holding period. There are long-term (held for more than a year) and short-term (held for a year or less) versions of the capital gains tax, and each has different implications for different types of stock options.
A cashless exercise provides employees with the funds to exercise their options using short-term loans provided by brokerage firms. This process is commonly referred to as a same day sale because employees can sell their shares on the same day they were exercised.
Fair Market Value (FMV)
FMV is the appropriate price for a certain property, such as company shares. The FMV can give startup employees an estimate of how much their stock options are worth at a given time. FMV can be determined by an independent appraiser.
Your grant letter – also called a “stock option agreement” – contains all of the critical information related to your stock options. This includes the number of options, the grant price, vesting schedule, expiration date, and the type of options i.e. ISOs, NSOs, etc.
The grant price – also called the strike price or exercise price – is the price that an employee will pay in order to purchase their company shares when they are exercising their stock options. Even when the market price for a company fluctuates in value, the grant price will remain the same.
A holding period describes the amount of time that an investment is held by an investor. For startup employees holding stock options, this describes the period between the exercise of your options and the sale of them. In many cases, the length of a holding period has significant tax implications.
Incentive Stock Options (ISOs)
Arguably, the best thing about ISOs is that they are eligible for special tax treatment. If you meet the various requirements, ISOs are subject to capital gains tax rates which are lower than ordinary income tax rates; however, you may be subject to alternative minimum tax (AMT) when you exercise your ISOs.
Non-Qualified Stock Options (NSOs)
NSOs are called “non-qualified” stock options because they do not qualify for the same favorable tax benefits that ISOs receive. Due to this, NSOs can be subject to taxation at exercise and when you sell your shares.
Ordinary Income Tax
Ordinary income tax (also called regular income tax) describes any type of income that is taxed at the United States’ marginal tax rates. This income includes wages, salaries, tips, and commissions.
Post-Termination Exercise (PTE) Window
The PTE window describes the period of time during which a person leaving a company can still exercise their options at the strike price outlined in their grant letter. For most startup employees, this means that if you’re leaving a private company, you have 90 days to exercise your options before losing all rights to the shares outlined in your stock option agreement.
Qualified Small Business Stocks (QSBS)
Small business stocks that qualify as QSBS are domestic C corporations whose assets are under $50 million. The capital gains from the sale of QSBS are exempt from federal taxes and can also benefit from favorable tax treatment if they were held for at least five years, if you are a non-corporate taxpayer, if the stocks exercised were issued after September 27, 2010, and if the stocks abide by various other nuanced regulations.
Restricted Stock Awards (RSAs)
RSA shares are given to employees on the same day that they are granted. They are typically issued before the first round of equity financing, when the FMV is very low. Depending on the nature of the offer, employees may either immediately own the shares, or still have to purchase the shares.
Restricted Stock Units (RSUs)
An RSU is essentially a company’s promise that you will receive shares at a later date, after various restrictions lapse. RSUs are not stocks and cannot be exercised, so no 83(b) election can be made.
The spread is determined by the difference between the FMV of your shares at exercise and the grant price.
Stock options give you the right to purchase shares of a company at a future date. Options are usually included in the compensation package that is offered by an employer; however, there is no obligation to “exercise your options,” a process that describes the purchasing of shares in the company. If you don’t yet feel confident in your understanding of stock options, check out part one of our Employee Stock Options Beginner’s Guide.
Tax withholding describes the amount of tax that employers deduct from an employee’s wages and then pay directly to the government. Also known as tax retention, these taxes are collected from the vast majority of people in the United States who earn income as an employee. The amount of income tax that your employer withholds from your pay depends on the amount you earn and on the information you put on IRS Form W-4.