let’s say, $x
Unfortunately x matters a lot here. So lets run an example at x=US$1.
Stock options come in two flavors: ISO and NQ. The tax treatment is quite different, so we will look at both cases. For simplicity we ignore the strike price since it’s essentially zero.
For NQ options exercising is a taxable event. the difference between the FMV and the strike price is taxable income, i.e. you owe taxes on $100k of exercise gain. If you are in the 22% tax bracket you need to come up with $22k to cover your tax bill. For ISO options, the exercise is NOT taxable, which is the beauty of ISO. However this beauty is immediately destroyed by the damnable AMT which makes no distinction between ISO and NQ. So chances are even if your options are ISO you’ll end up with a sizable AMT bill (let’s also call it 22k). In most cases this will eventually turn into refundable AMT credit but you still need to front the money.
Good case: Let’s say everything goes as planned and you can actually sell a year later at $5 for a total price of $500k. For NQ options you pay long term capital gains tax on $400k (which will be about $60k). So overall you pay 22k on the initial exercise and 60k on the one year gain for and you end up with a net gain of $418k.
For ISO options you pay long term capital gain tax on the entire $500k (ca. 80k) but you may be able to recover the AMT you paid during the exercise so you may end up with about $420k in your pocket (or extra AMT credit to be burned off in future years).
Bad case: Let’s assume the company wipes out and the value of the stock goes to zero. In this case, you end up with a capital loss of $100k. You can try to use this loss to offset gains in coming years but this is limited at $3k so it’ll take you 33 years to recover. Final outcome you have lost $22k in taxes and nothing to show for it.
The biggest problem with Scenario 1 is that you have to front a sizable tax bill at time of exercise. A) you need to have this money and B) this tax is entirely at risk until you have sold the shares at a gain. It’s risky.
One way to avoid having to front the money is to exercise very early in the year and then sell in the first quarter of the next year. If this works you have the money from the sale before April 15 so you can pay the tax bill for the exercise from the proceeds of the sale. Needles to say, that strategy is not for the faint of heart.
This is much simpler. You don’t have to front any money and no money is ever at risk. You just pay regular income tax on the full sell price. For a $500k gain this might be around $150k so you would net $350k. If the stick wipes out, you don’t gain anything, you don’t lose anything.
If all goes to plan scenario 1 will net you more money, but you may have to front a tax bill and if things go sideways you will might lose that tax payment.
Caveats
- The tax calculations depend A LOT on your specific details: filing status, other income, other deductions, the actual stock values
- State tax complicates things A LOT further (depending on the state)
- A licensed tax professional is likely to give you better advise than strangers on the Internet.
