Tax Overview & Glossary
This section reviews the definitions behind foundational concepts and tax
terms that appear throughout this guide.
(Because it's damn near impossible to remember all those acronyms!)
Key tax terms to master
You might feel overwhelmed by how much money it costs to exercise your options — and you might be surprised that it can come with a hefty tax bill. The type of options you have and the timing of when you exercise and sell them all influence how you're taxed. Brush up on the tax terms below to stay in the know.
Fair market value
Fair market value is the dollar amount that stock is worth on the open market. The taxes you pay when you exercise your options depend on the difference between the fair market value of your shares and the strike price you pay for them, often called the "option spread". You are always taxed on the option spread, and it's pretty straightforward: the bigger the difference, the more taxes you pay. (But the bigger the difference, the more money you make!)
If your company is private, your company's fair market value is determined by a 409A appraisal. The 409A appraisal (named after IRS Section 409) is an independent valuation required by law. It happens at least every 12 months, any time your company raises a new round of funding, or anytime there is a significant event at the company that could impact the valuation. (As companies get closer to IPO, 409A appraisals happen more frequently.) Usually, companies hire an outside firm to determine the 409A valuation. If your company is public, the fair market value is determined by the public price per share on the date the option is issued.
Short-term capital gains vs. long-term capital gains
As TurboTax explains: The IRS taxes different kinds of income at different rates. Capital gains (like profit from a stock sale) are generally taxed at a more favorable rate than your salary or wages. However, not all capital gains are treated equally. The tax rate can vary dramatically between short-term and long-term gains. Ideally you want to be taxed at the lowest possible rate: the long-term capital gains rate.
- If you sell equity that you've held for one year or less, any profit you make is considered a short-term capital gain. The clock begins ticking from the day after you exercise up to and including the day you sell it.
- Short-term capital gains do not benefit from any special tax rate — they are taxed at the same rate as ordinary income (for 2019, the rate ranges from 10-37%, depending on your total taxable income)
- If you hold your equity for longer than a year, you can benefit from a reduced tax rate on your profit when you sell it.
- For 2019, the long-term capital gains tax rates are 0%, 15%, and 20% for most taxpayers.
- For high-income taxpayers, the capital gains rate could save as much as 19.6% off the ordinary income rate.
Alternative minimum tax (AMT)
As TurboTax explains: The AMT is a parallel tax system that operates in the shadow of the regular tax, expanding the amount of income that is taxed by adding items that are tax-free and disallowing many deductions under the regular tax system.
AMTs come into play if you have incentive stock options (ISOs) — if you exercise ISOs but do not sell the stock in the year of exercise, the transaction is not taxable that year for regular tax purposes. However, the difference between the exercise price and the fair market value of the stock on the day of the exercise is an adjustment for AMT purposes.
For many people, this adjustment can be a very large number, and means ISOs require particularly careful financial planning. The AMT is sometimes called a "phantom tax," because in the year of exercise you may pay tax despite the fact that you haven't sold any shares or received any cash to help pay the tax. (Note that you can often recoup any AMT paid at exercise via a Minimum Tax Credit when you sell your options.)
The different types of equity and their tax implications
Your offer and additional equity grants might consist of just one type of equity, or a combination of stock options and restricted stock units (RSUs). The different types of equity you have affect how much you'll need to pay out of pocket down the road — both in terms of exercising your equity (if you have options) and the taxes you have to pay on it (for options and RSUs). Below are some of the basics about the common types of equity.
Typically it's not in the cards to negotiate for a specific type of equity.
The information in this section can be used to help you understand the financial implications of your equity offer.
Restricted stock units (RSUs)
RSUs are common at later-stage, more mature companies. If you're granted RSUs, you get to own them without putting any money down (no need to exercise). Think of these as an equivalent to a cash bonus, with similar tax implications.
As TurboTax explains, when you receive an RSU, you don't have any immediate tax liability. You have to pay taxes when your RSUs vest — at that point, you have to report income based on the fair market value of the stock. You'll likely have to pay taxes again when you sell stock you received through RSUs. After you pay the income tax on the fair value of your stock, the IRS taxes you the same as if you bought the stock on the open market.
Since stock you receive through RSUs is essentially compensation, you'll usually see it reported automatically on your W-2. Typically, taxes are withheld to go against what you might owe when you do your taxes. As with all withholding, the taxes your employer deducts from your paycheck may not be enough to cover the full amount of tax you owe when you file your return. If your employer doesn't withhold tax on your stock grant or RSU, you may be responsible for paying estimated taxes.
If your company is already public, holding on to RSUs after they vest is equivalent to taking a cash bonus and using it to buy your company stock at the current price. Unlike with options, there is very little tax advantage in holding the RSUs after they vest — you're better off selling immediately.
With options, you are allowed (but not obligated) to purchase a number of shares of the company stock at a fixed price within a certain time frame. Buying them is known as exercising, and the fixed price is known as the strike price. Naturally, the more options you are granted (and the lower the strike price), the better.
You may be granted incentive stock options (ISOs) or non-qualified stock options (NSOs, or NQSOs, or NQs: all the same!). ISOs have potential tax benefits — but also potential tax pitfalls.
The tax benefits of ISOs
As TurboTax explains, when you exercise ISOs, you buy the stock at a pre-established price, which could be well below actual market value. The advantage of an ISO is you do not have to report income when you receive a stock option grant or when you exercise that option. You report the taxable income only when you sell the stock. And, depending on how long you own the stock, that income could be taxed at capital gain rates which are typically a lot lower than your regular income tax rate.
With ISOs, your taxes depend on the dates of the transactions (that is, when you exercise the options to buy the stock and when you sell the stock). The price break between the grant price you pay and the fair market value on the day you exercise the options to buy the stock is known as the bargain element.
There is a catch with ISOs: You have to report that bargain element as taxable compensation for AMT purposes in the year you exercise the options (unless you sell the stock in the same year).
With NSOs, you must report the price break as taxable compensation in the year you exercise your options, and it's taxed at your regular income tax rate.
Typically it's not in the cards to negotiate for a specific type of equity.
The information in this section can be used to help you understand the financial implications of your equity offer.
The difference between ISOs and NSOs
At time of exercise
When you sell
At time of exercise No taxes due; does not trigger income tax withholding upon exercise (or Social Security, Medicare). But you may owe Alternative Minimum Tax on the option spread, which can be $$.
When you sell If held for two years after they're granted to you, and one year after you exercise, they're taxed as long-term capital gains when you sell — which means fewer tax dollars out of your pocket. (Otherwise, they're taxed as ordinary income.)
Exercise window Must be exercised during employment or within 90 days of last date of employment.
Also note: After receiving $100,000 worth of ISOs in any given year, the remaining portion of the grant will be treated as NSOs. (In fact, ISOs can automatically convert into NSOs under certain circumstances. Ask your employer about the specific circumstances for your company.)
At time of exercise Requires both employee and employer to pay Social Security and Medicare taxes, as well as income tax withholding, at the time of exercise. (Employers might like to issue NSOs because they offer certain corporate tax deductions that ISOs do not.)
When you sell If you exercise and hold for more than one year before selling, any gain or loss is considered a long-term capital gain or loss. (Shares held less than one year are taxed as short-term capital gains.)
Exercise window Eligible for an extended exercise window, depending on your company policy. For example, you might be able to exercise NSOs years after leaving your job.
Alternative minimum tax
AMT is a tax law designed to prevent wealthy taxpayers from using loopholes to avoid taxes. It works by expanding the amount of income that's taxable, and not allowing for standard deductions or any personal exemptions. AMT comes into play if you have incentive stock options (ISOs) — if you exercise ISOs but do not sell the stock in the year of exercise, the transaction is not taxable that year for regular tax purposes. However, the difference between the exercise price and the fair market value of the stock on the day of the exercise is an adjustment for AMT purposes. For many people, this adjustment can be a very large number, and means ISOs require particularly careful financial planning. Read more
Holding any extra cash on top of what you need in the near term is known as "cash drag" — cash that is underperforming compared to what you could make if that money were invested. History shows that financial markets rise over the long term, so excess liquidity means you could be losing out on some valuable returns. Read more
Otherwise known as "capitalization table." Basically, it's a summary of "who owns what" — according to Wikipedia, it's "an analysis of a company's percentages of ownership, equity dilution, and value of equity in each round of investment by founders, investors, and other owners."
This is when shares of a single stock represent a large percentage of your overall portfolio. Your wealth is concentrated in this single position. If you exercise your options or have RSUs, chances are a significant share of your wealth is tied up in your employer's equity. Our advice is to diversify out of this concentrated position (sell your stock) and build a portfolio across different asset classes so that you avoid taking on the risk associated with a single stock and the risk that the company will stumble. Read more
Common stock is what people refer to when they mention stocks on the stock market — it gives you some ownership in a company, voting rights, and dividends if the company does well. However, common stockholders are on the bottom of the priority ladder in the ownership structure. For example, if the company undergoes a liquidation event, the payout order is usually: bondholders, preferred shareholders, other debt holders, and then finally common stockholders.
The reduction in the ownership percentage of a company after new equity shares are issued. If your company raises more money and takes on more investors, they could issue more shares, and thus dilute the value of your shares. Your ownership will also be diluted when the company issues options or RSUs to attract new employees and/or retain old ones. But dilution isn't the end of the world — raising money to grow faster can make it worthwhile if it's meant to accelerate growth. Read more
This is when you spend a fixed amount of money on a certain investment by investing on a regular basis, no matter whether the price rises or falls. Studies have shown that dollar-cost averaging is likely to generate a larger amount of proceeds from the sale of your stock over time than trying to time the market. Read more
This is when the company's stock or convertible bonds are purchased at a lower valuation than the previous round in private financing. A down round might feel like a negative event, but that's not necessarily the case. It's very common for private company valuations to get ahead of the business. The valuation can rise much faster than the revenue in the beginning, especially in industries that have garnered a lot of hype. In these circumstances, it is not unusual for companies to have a down round. But if they continue to grow, then revenues catch back up to valuation, and value grows over time.
A stock option is the right, but not the obligation, to buy a share of the company stock at some point in the future — buying them is known as exercising. The most important variables to consider when deciding when to exercise your stock option are taxes and the amount of money you are willing to put at risk. Read more
In an early exercise, you purchase some or all of your unvested options upfront, then receive your shares at vesting time. Read more
Exercise and hold
This refers to the situation when you hold onto your company's stock after purchasing your option shares. Holding onto the stock means there's potential for you to receive dividends if the company is successful and its stock value increases. This is a strategy also used with incentive stock options (ISOs) — if you hold ISOs for at least two years from date of grant and at least one year from date of exercise, you'll receive long-term capital gains treatment when you sell. Read more
This is the period of time during which you can exercise your vested options at the strike price. If you fail to exercise your options within the exercise window, then you will lose your ownership of those vested stock options. After leaving a company, the clock will start ticking on your window to exercise the options you vested during your time there. The vast majority of companies give you 90 days from the day of your departure to exercise — so if you want to exercise, act fast.
Fully diluted shares
This refers to the total number of common shares of a company — including common stock, RSUs, preferred stock, outstanding options, and unissued shares remaining in the options pool.
This refers to the order and amount of payment investors will receive when a liquidation event happens. It dictates that the investors will be paid first, before the company's founders or employees can receive their returns.
This refers to a situation after an IPO, where employees usually can't sell their stock for up to 180 days. It's meant to prevent employees from all dumping their stock and depressing the stock price.
Long-term capital gains
Gains that you've earned on assets that you've held for more than a year.
The shares of a company stock that you have the option (but not the obligation) to buy at a fixed price within a period of time.Incentive Stock Options (ISOs)
A type of stock option that provides a tax benefit — on exercise, you don't have to pay ordinary income tax (but you may have to pay alternative minimum tax instead). If the shares are held for one year from the date of exercise and two years from the date of grant, then the profit made on sale of the shares is taxed as long-term capital gains.Non-Qualified Stock Options (NSOs or NQs)
Stock options which do not qualify for the same special treatment accorded to incentive stock options — NSOs trigger additional taxable income at the time of exercise, based on the difference between the exercise price and the fair market value on that date.
The difference between the fair market value of your shares and your strike price. The option spread will decide the taxes you pay when you exercise your options — the bigger the difference, the more taxes you pay (but the bigger the difference, the more money you make!).
Includes wages, salaries, tips, commissions and interest income from bonds. It's taxed at U.S. marginal tax rates. However, ordinary income excludes long-term capital gains and dividends, both of which have lower tax rates.
Investing in a globally diversified portfolio of low-cost index funds. Read more
Preferred shareholders are guaranteed an income from dividends, and preferred stock comes with the right to preferential treatment in a liquidation event. Usually, venture capitalists receive preferred stock in the startups they invest in.
Restricted Stock Units (RSUs)
RSUs are shares of common stock subject to vesting, granted once you achieve certain performance milestones, or after you've remained with your employer for a certain length of time. You don't have to exercise or pay for the stock, but you do have to pay taxes when your RSUs vest — at that point, you have to report income based on the fair market value of the stock. RSUs are often found at later-stage, more mature companies.
Short-term capital gains
The profits you gain from selling assets that you've held for one year or less. Short-term capital gains don't benefit from any special tax rate, and are taxed at the same rate as your ordinary income.
This could be an individual or institution that owns shares of a company, public or private. They are paid dividends if the company makes profits and its stock valuation increases. A shareholder owning over 50% of a company's outstanding stock is a majority shareholder.
The total number of shares of a company that all investors — institutional or employees — currently own.
The fixed price at which you will be able to exercise (purchase) your options. Naturally, the lower the strike price, the better. (Note: Only a board of directors can set the strike price, so your grant and strike price will be confirmed at the next board meeting after you join a company.)
Secondary sales that companies arrange with private buyers that allow employees to sell up to 20% of their vested shares. They are becoming more popular these days because companies are taking much longer to go public than they did in the past — meaning employees have to wait much longer to recognize liquidity from their hard-earned equity unless there is a secondary sale of the stock available.
The process by which you earn your shares over time. The typical vesting schedule is over four years with a one-year cliff — meaning that on your one-year anniversary, you will have vested 25% of your initial grant. After the cliff, your options will vest monthly until you are fully vested after four years. Vesting acceleration happens when your stock vests faster than the original schedule dictates — if your company gets acquired or participates in a merger.
A warrant gives you the right to buy or sell the stock of a company at a fixed exercise price before the expiry date. It's similar to options in a way that they both allow the holder rights to buy shares and have stipulated expiration dates. There are two types of warrants: a call warrant gives you the right to buy a stock, and a put warrant gives you the right to sell a stock.
This is a trading plan offered by companies for you to specify when you will buy or sell shares at specific, scheduled times. This is usually only made available to C-suite or executive-level employees to help them buy or sell shares without violating laws against insider trading. But employees at more levels are being offered 10b5-1 plans these days.
409A appraisal &
fair market value
An independent valuation to determine the fair market value of the company's common stock. Required by law, it's named after IRS Section 409 and happens at least every 12 months; any time your company raises a new round of funding; or anytime there is a significant event at the company that could impact the valuation. (As companies get closer to IPO, 409A appraisals happen more frequently.) If your company is public, the fair market value is determined by the public price per share on the date the option is issued.
This is a special election you can make with the IRS to let them know that, despite the fact that you have not yet vested your stock, you still want to recognize the income associated with ownership immediately. The benefit? You won't have to pay any taxes when you early exercise. If you decide to exercise your options early, it's important to make an 83(b) election within 30 days. Read more