Stock options could qualify for QSBS after they are exercised, but there are a few steps you should take before exercising your options. If you are concerned about the tax implications of selling or exercising your stock options than you are in the right place. First, we will delve into the QSBS level tax implications and then drift into what the pros and cons are for the timing of exercising your options.
To pin down if your stock options qualify for QSBS, whether exercised or not, you should first go through the QSBS checklist and speak with your company, accountant, or attorney to gather the right information to answer the checklist. If the company qualifies as an eligible QSBS corporation than it is up to you to stay compliant with the section 1202 QSBS requirements. One of the requirements for the QSBS acquirer is that they have to hold the stock for five years before selling. The five year holding period does not start for stock options until the day they have been exercised and the stock is issued; therefore, you will want to exercise your options as soon as possible for QSBS purposes. Once exercised there are ways around the five-year holding period if the stock is sold early by taking advantage of the section 1045 rollover. If your stock options do qualify you will save up to 23.8% on capital gains taxes when the stock is sold. Even though the tax savings are attractive it could come with a few trade-offs if the stock is exercised early, depending on if your shares are qualified or non-qualified. Below is a real-world example of exercising your stock options if they are qualified.
Below is a hypothetical example.
ABC Corp hired a CFO, giving him 5% of the employee stock options pool that vests over 2 years and currently qualifies for QSBS. At the end of the two years, Mr. Smith exercised all of his options for $1000,000. The CFO sold his stock options to a private equity firm for $10,050,000 the day after his five year QSBS holding period was up. Due to the QSBS qualification, he saved $2.38 million in capital gains taxes ((10,000,000 – 50,000) x 23.8%). Also, these tax savings do not include the potential state income tax savings he might have as well.