The Tax Mistakes That Turn Employee Stock Options Into a Financial Nightmare

Stock options sound great. For people at private tech start-ups, it’s where all the stories of overnight riches usually begin. Until tax season hits and you owe way more than you expected.

I’ve seen people exercise options, thinking they’re cashing in on their hard work, only to watch half of their earnings disappear to taxes. Others get hit with Alternative Minimum Tax (AMT) and don’t even know what it is until it’s too late.

Most of these tax hits are avoidable. But only if you understand how ISOs and NSOs work before you exercise.

ISOs vs. NSOs: It’s All About the Taxes

The rules for Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) aren’t minor details. They can make the difference between keeping more of your earnings or handing a big chunk to the IRS.

NSOs: Taxed Like a Bonus

NSOs are straightforward. The IRS treats the difference between your strike price (the amount you pay to buy the shares) and the stock’s market price at exercise as ordinary income.

If you exercise 10,000 NSO shares with a $10 strike price when the stock is worth $50, the $40-per-share gain is taxed just like your salary. Depending on your tax bracket, you could lose nearly 40% of it to federal and state taxes right away, whether you sell or not. For this reason, NSOs can be really tricky, especially if you’re forced into an exercise decision, such as when leaving an old employer.

ISOs: A Tax Advantage But With a Catch

With ISOs, you don’t owe taxes at exercise, unless you trigger AMT. The catch is you must hold the shares for at least one year after exercising the options and two years after the options were granted to you. And then any profits qualify for lower long-term capital gains tax instead of ordinary income tax.

ISOs can put you into Alternative Minimum Tax (AMT) territory, taxing you on paper gains that don’t exist yet. This can be an enormous problem for people and something you may not realize until many months later, with no ability to reverse. You must know how to calculate this before making a decision (more on that below)

The AMT Trap That Costs People Thousands

Most people never fall into a situation where AMT is applicable and therefore have never even heard of it. So what is it? AMT is a separate tax calculation designed to prevent high earners from paying too little tax. Exercised ISOs are included as what is factored into this parallel tax system. If the spread between your strike price and the market price at exercise is big enough (and you exercise enough shares), the IRS taxes it, even if you don’t sell the shares.

A Real-World Example

You exercise ISOs at $10 per share when the stock is trading at $50. If you have 10,000 shares, the "phantom gain" for AMT purposes is $400,000. Now, depending on your tax situation, you could owe AMT this year, even though you haven’t sold anything and have no actual cash in your pocket (or no real way to sell the shares even if you wanted to).

If the stock drops before you sell, you’re stuck in a terrible spot: You already paid tax but now your shares aren’t worth much.

Your Next Steps

A little planning can save thousands in taxes. And a massive headache. Here’s what to do before exercising stock options:

1. Identify What You Have

Look at your stock option agreement. Are they ISOs or NSOs? Make sure you know:

• Your strike price

• Vesting schedule

• Expiration dates

2. Estimate Your Tax Bill Before Exercising

Use my free ISO/NSO tax calculator or work with a professional to model different scenarios. Run the numbers on:

• AMT impact if you exercise ISOs

• Ordinary income tax impact if you exercise NSOs

• What happens if you hold vs. sell immediately

Leverage my free model to evaluate your tax impact to make better decisions. Included in the link is a video walkthrough, making it easy to follow.

3. Plan Your Exercises Across Multiple Years

Exercising everything at once could push you into the highest tax bracket or trigger AMT. Spreading it out across multiple tax years can help reduce the hit.

When it comes to start-up stock options, the name of the game is keeping your out-of-pocket costs as low as possible, while simultaneously building an ownership position in the company (i.e., exercising options for shares).

4. Have a Liquidity Strategy

If you owe taxes before you sell shares, make sure you have a plan to cover it. That might mean holding back personal funds, selling a portion of your shares (if that’s even possible - often it’s not), or timing your exercise carefully.

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Wrap-Up

Stock options can be the most powerful wealth-building tool if you use them correctly. The wrong moves can mean unnecessary taxes, lost value, and financial headaches.

Don’t wait until tax season to figure it out.

Book a free consultation to make sure your stock option strategy is the right one.