I am not a lawyer or tax attorney. Please consult with one before making any financial decisions as to what to do or not do with your options. Stock options are complicated; the paperwork that accompanies them can sometimes be a full inch thick of financial legalese.
Most employees are just glad to get some ownership in the company — and maybe a lottery ticket if the startup does really well. For the executive summary: If you can afford it, forward-exercise percent of your options the week you join a startup and file an 83 b election immediately. Wow, that sounds like a lot of money! Oh, and in many deals, most of this money is not doled out right away to employees. Even if the startup eventually gets acquired for a billion dollars, you get zilch.
This mistake can catch a lot of otherwise smart people. They join a startup, work hard and see the company grow. Then after a few years they say: The employee feels not only pumped but really, really smart. After all, they just paid this tiny price to exercise their options, and in return they get this big wad of super-valuable stock!
In two cases, friends of mine had to arrange for a decade-long repayment period to the IRS for hundreds of thousands of dollars, wiping out their savings and their next decade of earnings. But follow this carefully: Restricted Stock can be purchased back from you by the company at the amount you paid for it if you quit. The next day, you forward-exercise your four-year option package and quit. The restricted stock vests into common stock at the same schedule as your options vest.
This also means you get to start the clock ticking on long-term capital gains, which is currently 15 percent in the US! So if your company does end up hitting a liquidity event, a much smaller portion of your gains will be taxable. Indeed, if you hold on to your stock for more than five years, you might be eligible to roll over all of the proceeds into another qualified small business completely tax-free! Some folks who are clever enough to realize that they can exercise early unfortunately forget that they need to tell the IRS to recognize the event with a form called an 83 b election.
He is dweekly on Twitter and can be reached at david weekly. Exercise options early and file 83 b: Dave, I recently had to get creative with compensation at my company, so ended up building http: We were paying people startup wages and, once revenues started coming in, we faced a problem: Stock-options and equity distribution were not a good short-term solution, so I tried to implement a program that:.
The compensation pool is a set percentage from the profit margin. Once you start working with us, your ownership will increase to its maximum over a period of 2 years. Once you leave, your ownership will go down to 0 over 2 years. We are using the logistic curve to calculate growth of ownership over time. Here is a sample scenario: P1 then hires P3. A year from then, P1 is at 2, P2 is at 1, P3 is at 0. And so each gets their portion: In the end, the idea is simple: Moreover, you have a career path going up levels and then there can be a performance multiplier allowing management to rate your performance.
Sorry for the long post, but I thought you may find this interesting and am very curious about your thoughts on this. The whole point of options is to let you buy stock at a lower price than the stock is currently. If you exercise them immediately upon receipt, you will have to pay the company exactly what the stock is worth. You just became an investor, and a start-up would have to be pretty hot for you to say that the privilege of investing in the company is compensation for being an employee most likely, as mentioned, at a salary less than market.
The whole point of options is that if the company tanks you will have paid nothing for the chance to participate in the upside. Tax implications aside, an un-exercised option is ALWAYS worth more than the difference between the strike price and stock price. Early exercise is not a decision to take lightly, the idea is to maximize your NPV, not just your future tax liability. In the formation stages, Common might even be priced at fractions of a penny! Consequently, while you are making a bet, it is a bet that is cheaper to make sooner rather than later when serious tax consequences could come into play.
This article is perfect. Is exactly the same I told to every startup who promised me wonderful magical stock insteade of the real value of a super work. You forget to file an 83 b. What is your tax status? There is no risk of forfeiture in your example so no 83b is needed.
If you exercise vested options, the taxable event is always at exercise, for regular tax as well as AMT. Only when you exercise unvested options does 83b and AMT come into effect, because it regulates the treatment of vesting as taxable event. When you join a start-up, consider asking for a signing bonus to cover after tax the pre-exercise!
I will preface this by saying I am a tax attorney, but this information does not constitute tax or legal advice. Please consult a tax professional. The recognition income from the exercise of an option depends on the type of option. If certain holding period requirements are met then there is no income recognized from its exercise, contrast non-quals in which there is income recognized equal to the intrinsic value of the stock received, fair market value less price paid to exercise.
The income from exercising an option is gross income for both regular tax and alternative minimum tax AMT purposes. AMT is an alternative system that starts with regular taxable income and makes certain adjustments and preferences, but at the base both AMT and regular tax rely on gross income under IRC Section Many companies provide way to mitigate the tax that may be due upon the exercise of a 83 b election or taxable option exercise, including trading in some of your options for cash to pay the taxes on the options exercised.
Everyone should consult with a tax professional before exercising any substantial amount of options. It completely depends on your option if you have the ability to convert to restricted stock before you can exercise, but in my experience that would be rare. These are different than options in that they are actual stock, with restrictions, i. Another difference is with regard to when the income is recognized for tax purposes. Income from non-quals for instance, are recognized upon you exercising the option — you decided to exercise and paid cash or performed a cashless exercise, while for restricted stock there is no cash due and vesting happens automatically based on the deferred compensation plan.
The restriction on the stock was that you have to give it back if you leave, which leads to the substantial risk of forfeiture that prevents it from being income when received. Filing an IRC Section 83 b election is an important consideration and should not be taken lightly. An 83 b election, which applies to restricted stock, changes the character of the future income from the sale of the stock.
However, if you had made an 83 b election at the date of grant you would recognize only ordinary income equal to the FMV of the shares at the grant date, and only recognize capital gain or loss when sold. But, and this is a big but, if the stock goes down in value you could have some trouble. On subsequent sale you would recognize a capital loss, which, is severely restricted in your ability to deduct those losses.
You may have just picked up ordinary income in the year of grant but then be severely limited in your ability to recognize a loss on the sale. The first edition got a number of such bits of constructive feedback that were incorporated into the second edition of the Guide embedded above.
I did have a few other comments to your responses:. ISOs are becoming less and less common, especially as companies grow. Many of my large clients have abandoned ISOs. Under ISOs an individual includes income, and the company only gets the tax deduction. However, a lot of people will fail to report the DD if they can sell the stock publicly, and as a result the issuers lose the tax deduction. Even non-public companies are limiting uses of ISOs anticipating future problems.
Nevertheless, I think its important to point out there is a distinction. I do think some clarification could be made to with respect to the holding period for ISOs.
The reason for the income is under 83 c 1 — substantial risk of forfeiture. Upon the lapsing of the restriction, i. You are merely awarded the stock subject to vesting. Therefore when they vest you pickup the income, or, if at grant you file an 83 b election, you pickup income equal to FMV of the stock. Another consideration is the deferral of tax.
Though this is a gamble. I think my point is not that its never a good idea to make one, it certainly is in a good number of circumstances, only that there should be careful consideration of if the 83 b should be made. Based only on anecdotal evidence i. Your calculation in 1. Series A these days? Stock-options and equity distribution were not a good short-term solution, so I tried to implement a program that: Great David Nunzio Thanks, Nunzio!
Does anyone happen to know the tax consequences of forgetting the 83b? Thanks for the answer. I really appreciate it. I did have a few other comments to your responses:More...