When exercising your stock options goes wrong

“I’m rich b***h” - Dave Chapelle

I’ve seen many horror stories of people incorrectly exercising stock options and owing tons in taxes.

Here’s what you need to know so that this doesn’t happen to you:

The type of stock option (NSO v ISO):

Both Non-Qual Stock Options and Incentive Stock Options allow you to (potentially) purchase your company’s stock at a price far below market value (aka strike/exercise price).

The major difference between the two is that:

With NSO’s the spread between the market price and your purchase price is taxed as ordinary income whereas with ISO’s it is not.

If you’re able to purchase 100 shares of your company’s stock at a strike of $1 when its market price is $10, the $900 difference is taxable with NSO’s and not with its alternative (ISO’s).

How long to hold the stock:

Once you exercise your stock option and purchase your company’s stock, however long you wait to then resell your stock will determine the amount in taxes you pay.

For NSO’s once exercised you need to wait a full year to sell your stock at a lower tax rate (long term capital gains rate).

For ISO’s you also need to wait a year with one caveat — there is an additional two year waiting period tacked on to whenever your employer gave you the options.

In either case if you decide to resell your shares sooner, you will pay taxes on the gains of your options at a less preferable tax rate.

Watch out for the AMT:

The Alternative Minimum Tax Rate is a concurrently calculated tax liability to ensure you don’t pay too little in taxes.

The TLDR on it is that when you file taxes you will owe the greater of:

Whatever the AMT says you owe after you’re able to make a few deductions.

Whatever your separately calculated tax return says you owe, after you’re able to make many more (deductions).

In the context of stock options it’s important because ISO’s will count the previously described “spread” between purchase and exercise price as income in the calculation of your AMT tax liability.

For example:

I exercise 10,000 ISO’s at $1 when they’re worth $10… a $90,000 spread.

For your main tax return that $90,000 difference is not counted as taxable income.

For your AMT tax return it is.

If after deductions (on both tax returns), you owe more tax on your AMT, rather than your main, then you must pay the higher tax.

Cheers