dangerWhen you get stock options and are considering if and when to exercise, you need to think about the taxes and when you owe them. In principle, you need to think about taxes you may incur at three points in time:
important If you’re granted ISOs or NSOs at a low strike price, and the bargain element is zero, then you may be able to exercise at a reasonable price without triggering taxes at all. So assuming the company allows it, it makes sense to early exerciseimmediately (buying most or all of the shares, even though they’re not vested yet) and simultaneously file an 83(b) election.
caution An 83(b) election, as already discussed, is the choice to be taxed on the receipt of property even though you might have to forfeit or give back the property to the company. You can make an election on the receipt of stock, but you cannot make the election on the receipt of a stock option or an RSU because options and RSUs are not considered property for the purposes of Section 83(b).
cautionISOs are often preferred by startups, as they’re supposedly better for employees from a tax perspective. This assumes that (1) AMT won’t be triggered and (2) you’ll get a low long-term capital gains rate by holding the stock for the appropriate holding periods. However, often you either run afoul of the AMT trap, or don’t hold the stock long enough with the complicated 1 year + 2 year requirement, or the spread at exercise is small or zero, so the difference wouldn’t matter anyway. NSOs do have a slightly higher tax because of the need to pay employment taxes on NSOs and not ISOs.
controversy Overall, it’s not clear the ISO is that much better for employees, so many people argue for NSOs instead.
confusion This is partly because ISOs can make it harder to meet the long-term capital gains holding period.* Many people expect early exercise, together with an 83(b) election, will help them hold the stock long enough to qualify for long-term capital gains. While this is true for NSOs, a murky part of the rules on ISOs states that even with an 83(b) election, the capital gains holding period does not begin until the shares actually vest. So if you want to immediately exercise an option and file a Section 83(b) election, and you might have liquidity soon, it’s better—for those who can—to do so with NSOs.
The AMT Trap
When it comes to taxes and equity compensation, one scenario is so dangerous we give it its own section.
danger If you have received an ISO, exercising it may unexpectedly trigger a big AMT bill—even before you actually make any money on a sale! If there is a large spread between the strike price and the 409A valuation, you are potentially on the hook for an enormous tax bill, even if you can’t sell the stock. This has pushed people into bankruptcy. It also caused Congress to grant a one-time forgiveness, the odds of which happening again are very low.
Definition The catastrophic scenario where exercising ISOs triggers a large AMT bill, with no ability to sell the stock to pay taxes, is sometimes called the AMT trap. This infamous problem has trapped many employees and bankrupted people during past dot-com busts. Now more people know about it, but it’s still a significant obstacle to plan around.
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