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How do stock options work?

Stock options give the recipient the right, but not the obligation, to purchase shares of company stock at a predetermined price for a certain period. If the price of the company stock increases, the option holder will be able to purchase shares at a lower price than the current market price once the options vest (or the plan may allow for early exercise). Stock options have a lot of financial leverage, meaning if the stock goes up a lot you can receive a huge amount of value. From the recipient's perspective, ISOs and NSOs differ only in their tax treatment, with ISOs being eligible for more favorable capital gains rates if certain restrictive conditions are met. 

How are NSOs taxed?

There’s no tax event when the option is granted. Upon exercise, the bargain element (e.g. the difference between the market price of the shares and the exercise price) is taxed at ordinary income tax rates. From the exercise date onward, any gain or loss in the shares will be treated as short or long-term capital gains, depending on how long you hold the shares. NSOs are much more flexible (no required minimum vesting period, no restrictions on the amount that can be granted, no holding period requirements, and not subject to AMT). 

When does early exercise make sense? 

Many plans will include an early exercise provision, which allows the employee to exercise her options before they are vested. Generally, you would not pay tax until the options are both vested and exercised; however, if you elect for an early exercise and make an 83(b) election, you can lock in the taxes at a time when the bargain element is hopefully smaller, and then receive capital gains treatment on any further appreciation. Anytime you make an 83(b) election, you’re making the bet that the shares will continue to appreciate. There is always the risk that they won't and you cannot get that tax payment back. If you anticipate a significant increase in share price, such as from an IPO, the 83(b) election on a stock option or restricted stock award may be wise.

What is a qualifying disposition of an ISO?

Qualifying incentive stock options (ISOs) are eligible for favorable tax treatment if certain conditions on the issuing company and the employee exercising the options are met. To qualify, the plan must include a minimum one-year vesting period. Only the first $100k of options that vest in a given year are entitled to favorable ISO treatment (the rest are treated as NSOs). For ISOs there is no regular income tax event when you exercise (unlike NSOs), however, you may be subject to the Alternative Minimum Tax, as ISOs are an AMT preference item. If you hold the shares for a minimum of one year from the exercise date and two years from the grant date, the bargain element will receive long-term capital gains treatment. Any AMT you owed at exercise will become a tax credit upon the sale of your shares. If you end up selling before reaching the holding period requirements, the bargain element will be taxed just like an NSO (ordinary income rate). To avoid dealing with AMT, it can make sense to exercise up to the AMT threshold or make an 83(b) election to limit future tax exposure, but these strategies carry their own risk…

What is a cashless exercise of a stock option?

Often, companies will allow a “cashless” exercise, whereby the holder does not have to put up the cash needed to purchase the shares upon exercise. Instead, the employee just receives fewer shares, which are equal in value to the difference between the exercise price and the current market price. This is the same net result as if you had put up the cash and then immediately sold the shares needed to cover the exercise price. A cashless exercise is certainly convenient (no large cash outlay, and no AMT), but you will forgo the potential for more favorable tax treatment, just like an NSO.