editione2.1.1Updated September 12, 2022
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.
new In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), which increases AMT exemptions and their phaseout thresholds. This means fewer people will be affected by AMT in 2018 and later than in prior years.*
Note that if your AMT applies to events prior to 2008, you’re off the hook.
Understand this topic and talk to a professional if you exercise ISOs. The AMT trap does not apply to NSOs.
Because the differences are so nuanced, what follows is a summary of the taxes on restricted stock awards, ISOs, and NSOs, from an employee’s point of view.
Restricted stock awards. Assuming vesting, you pay full taxes early with the 83(b) or at vesting:
if 83(b) election filed, ordinary tax on FMV
none if 83(b) election filed
ordinary tax on FMV of vested portion otherwise
long-term capital gains tax on gain if held for 1 year past when taken into income
ordinary tax otherwise (including immediate sale)
NSOs. You pay full taxes at exercise, and the sale is like any investment gain:
At grant and vesting:
ordinary income tax on the amount by which the FMV of the shares received exceeds the exercise price
income and employment tax withholding on paycheck
long-term capital gains tax on gain if held for 1 year past exercise
short-term capital gains tax (ordinary income tax rates) otherwise (this includes immediate sale at exercise)