What are the tax implications of NSOs?
ISOs are a pretty huge gamble, basically a lotto ticket, if you leave before a liquidity event occurs or is known to be on the near horizon.
But you have NSOs though, not ISOs right? From what I understand, ISOs are required by law to have a 90 day exercise window, so companies that offer more than 90 days after leaving a company are having ISOs converted to NSOs. When you exercise the NSOs, you still will have a tax bill.
I get this in theory, but there are also tax implications here, and it requires a lot of extra effort. I am not trying to excuse companies from not doing this, but its not as easy as just saying you will.
Options are typically ISOs, but by law, you have a max of 90 days to exercise an ISO after you leave. The only way around this is to instead offer NSOs, which have higher tax implications.
Third, you could offer ISO's, then convert them into NSOs when you leave, but its a lot of extra effort and paperwork.
Wouldn't that only be an issue if a company offers NSOs instead of ISOs? What I've seen in the past is "here's some ISOs, they automatically convert to NSOs 90 days after you leave." That way you get all the benefits of an ISO (tax on sale) while you work there, then all the benefits of an NSO (doesn't disappear in a puff of smoke at day 90). Seems like strictly a win, regardless of company phase.
An increasing number of startups issue their grants such that they qualify as ISOs if exercised within the 90-day window but automatically convert to NSOs 90 days after departure (with the actual exercise deadline dependent on employee tenure), so that the employee and their tax advisors at time of departure get to decide how to handle the tradeoff of more time for reflection vs better tax treatment.
What's more, if an employee gets more than $100k of exercisable options in a year - very possible especially in cases where early exercise is allowed - only $100k of those are treated as ISOs. There's no way in which the tax law privileges a short post-termination exercise period for the excess above $100k.
Last, some companies use the same options plan both inside the US and outside, including my two most recent employers. Most employees working outside the US, with some exceptions like US citizens and green card holders, wouldn't have to care about this US tax law nuance.
It's true that a company can't issue ISOs if the termination window is more than 90 days, they have to be NSOs instead. IMO the downside of the NSOs (pay tax immediately upon exercise instead of at next year's tax deadline - ISOs don't actually change the amount of tax that is due, just the timing of when you pay it) is small compared to the very real risk that your options will go poof if you don't have the cash to exercise and pay tax if there is a termination event.
There are two types of options, NSO and ISO. You want ISO as an employee because it's better for taxes, but that has a 90-day exercise window set by the IRS. You can push for yourself paying higher taxes in exchange for more flexibility, but it's a tradeoff.
- If you join as an early employee, your strike price is minimal and this isn't a concern at all
- If you want to minimize risk in return for higher taxes (call ~40%), just hold your ISOs and exercise-and-sell as a same-day sale when you're liquid (ie forgo the tax advantages of ISOs). There's absolutely no way for you to get screwed over if you're willing to take the gain as standard income.
Now it's 500k, the entire concept of ISOs is actually somewhat useful. Exercising a bit each year doesn't have hilarious consequences where the tax cost to exercise is 4 times more than the strike price itself.
In my experience, small startup options don't get exercised because of the tax bill, not because of the strike price.
In some ways that's true. Taking your list in order:
1. ISOs do have special tax treatment, but it only comes into play if you exercise them and the shares have increased in value (and it gets complicated if they've increased so much that they trigger the alternative minimum tax). Good companies though will let you exercise as soon as you join, so there's no tax at all until you sell. ISOs do nothing in that case.
2. NSOs are basically just standard call options. Most companies still force you to exercise or abandon your options after leaving, but good companies will convert your ISOs to NSOs and give you 10 years from the original grant to exercise them.
3. Startups doling out RSUs use triggers instead of handing out the shares directly (a taxable event), which is absolutely a tax dance. You also need to read the fine print on these, because some companies are evil and set it up so that you lose the RSUs if you leave.
4. The 409A is just a process for valuing the company. Keeping the value of the common shares low can be useful for taxes when the company uses options (less likely to trigger the alternative minimum tax), but that's not really why we do it. When a company uses RSUs, on the other hand, pricier is often better. Which is the natural progression of things anyway. The earlier a company is, the bigger the delta between the common and preferred share prices. Later on they converge, and when the company goes public, the preferred shares actually convert to common.
What restrictions do you mean? ISOs are better for the employee because any gain on exercise is not taxed as regular income. If the value is high enough the employee might be subject to alternative minimum tax (AMT), but the possibility of paying no tax is a benefit over NSOs whose gain is taxed as regular income and is subject to tax withholding.
If you get ISOs (not NQSOs) and you early-exercise them such that the spread is $0 (or at least negligible/low) and you correctly file an 83b and the IPO or exit is more than two years from date-of-grant and one year from date-of-exercise, then you can get the more favorable long term capital gains tax treatment on the generated income from the exit event.
That’s a lot of conditions, so IMO they don’t make all that much sense and I much prefer RSUs (maybe I’d think differently as a founder). Plus there are sharp edges like AMT. I’ve been an early employee multiple times at companies that had successful exits and never successfully had all conditions satisfied, and have ended up paying regular income tax rates but had more complicated taxes to file.
If joining a company as a non-founder I’d just take straight RSUs.
ISOs convert to NQOs once a certain amount of time has passed after leaving the organization, so there's not much difference there.
Having ISOs matters most when the underlying shares are illiquid, and you can defer the tax obligation until a sale event (provided you don't hit AMT). When you have a 7-10 year exercise window, the company will likely have IPO'ed or have failed. The tax benefit of ISOs are greatly diminished.
To realize the benefit of ISOs you need long term gains treatment. That requires you "prepay" tax when you execute. It's the difference between 20% and 33%+ effective tax rate.
That's only true when the value of your options is pretty small. ISOs are taxed under the AMT plan as regular income at a rate of 26-28%, and so you might be forced to pay taxes on them anyways.
Source: I had a fat AMT tax bill precisely because of this. :/
Even with this, if they're ISOs they'll transfer to NSOs after 90 days. This probably didn't matter before, but the new tax law in the US increases where AMT kicks in from around 120k to 500k.
This means that ISOs can probably be exercised tax free, but NSOs require you to pay taxes on the spread from strike to the fair market valuation.
If your strike price is low enough you may be able to save and afford to exercise the ISOs, the NSOs will probably be too expensive with the tax burden.
There's also a 10yr expiration on options anyway so it's possible that you could lose them even if you're waiting for an IPO while holding unexercised NSOs.
Really the best strategy is ISOs that convert to NSOs with 10y exercise windows when you leave. best of both worlds.
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