The combination of tax and timing can create a moving target when trying to pin down when to exercise stock options. The tax effects of exercising stock options are also dependent on whether the stock is an incentive stock option plan (ICOs) or non-qualified stock options (NQSOs). ICOs are not taxed as ordinary income on the exercise date; therefore, they are not added to the employees W-2 as compensation. On the other hand, NQSOs are taxed as compensation with taxes on a federal and state level. Although there are various tax implications it can be imperative to meet the Section 1202 requirements to take advantage of up to a 100% capital gains tax exclusion. First, let’s walk through an example of owning NQSOs.
Generally, NQSOs are taxed as ordinary income on the exercise date, unless there is a readily available market that the stock is traded on then the stock would be taxed on the grant date. The tax paid on the options when they are exercised is the fair market value (FMV) minus the strike price (i.e. price paid for the stock). Another variable to consider is how long the vesting is for the stock options and whether the company allows an early exercise by making a Section 83(b) election. In many cases, an early exercise could shield the stock option holder from the pre-exercise gain that is taxed as ordinary income. An early exercise can give you a tax advantage by decreasing the ordinary income taxed as a pre-exercise gain and start the holding period for QSBS earlier, but it does give the stockholder a lower cost basis in the stock. The reason the stock basis matters is because it allows you to obtain a higher capital gains tax exclusion for QSBS (e.g. 10x the initial basis). One last variable to consider with the timing and taxes of NQSOs is if the stock has a high FMV then there is a risk of decretion in the stock price after paying high ordinary income taxes on the current FMV. Considering all the above factors it is best to exercise the options as soon as possible for QSBS purposes to take advantage of the 100% capital gains tax exclusion on the sale of the stock.
Now let’s take a look through the lens of ICOs. ICOs are straightforward, they are not considered ordinary income when the stock is exercised; therefore, an ICO holder will want to exercise their options as soon as possible to start the clock for the QSBS five year holding period. If ICOs are exercised and not sold in the same year the difference between the FMV and the strike price on the exercise date will be taxed as an alternative minimum tax (AMT). The requirements for maintaining ICO status is in parallel with the QSBS requirements because ISOs must be held for one year after the exercise date and two years after the grant date.