Last month, my D exercised the options granted to her four years ago when she began working at her company – which has now pretty successful. She paid .05 for options valued at about $2.50 on her certificate. She understood that she would have to pay taxes next April on the difference. She was only one of a handful of early employees to stay long enough to vest.
Now, the company is saying that the stock is worth significantly more and the employees who exercised will have to pay the difference between the larger amount - she doesn’t even know the exact number, but several times higher than the $2.50, which will make her AMT almost $200K.
The company is offering to buy (she says it’s pressuring) back some of the stock so these employees can cover their taxes. All involved are pretty freaked out – none of this was disclosed a month ago when most exercised their options. They all thought they were doing the smart thing by buying before the new valuation.
Incentive Stock Options (ISOs) that are exercised to purchase shares that are not sold within the same tax year could result in AMT taxability of the bargain element (the difference between the options’ strike price ($0.05 per share in your example) and the fair market value ($2.50 per share in your example), so $2.45 per share in your example).
See line 2i of IRS Form 6251 and instructions.
https://www.irs.gov/pub/irs-pdf/f6251.pdf
https://www.irs.gov/pub/irs-pdf/i6251.pdf
If you web search for “ISO AMT”, you will find many web pages on the subject.
Many people who receive ISOs as part of employee compensation do not exercise until they are ready to sell the resulting shares in order to avoid AMT complications.
Thanks @ucbalumnus Unfortunately, she did not know that she could wait to exercise the options. Is the fair market value the price when she exercised the options - the $2.50? If so, that’s not too bad, but she’s concerned that the valuation will increase in the next few months to over $14 and she’ll have to pay the difference between $14 and $0.05.
UCB - that was NOT helpful. Anyone can google that crap.
I assume these are ISOs, correct? I also assume that $2.50 was stated as a fair market value on the date of the option exercise… I also assume that the company was gearing to go public at the time the options were exercised so a new, higher valuation could have been already in play. It is possible that the company incorrectly valued the shares on the date of her exercise or incorrectly reported the value to the employees… This needs to be clarified. I highly recommend talking to a tax professional or a CPA who deals with incentive stock options.
The company is at fault for not explaining to employees the tax consequences of exercising stock options; often companies in this situation do explain it to employees. Also, people in places where there are a lot of start-ups often know about this. But taxpayers are responsible for understanding the tax consequences of their actions.
Normally, the person who exercises the options would then sell some of the stock to cover the tax. Do I understand that the stock is not now traded on an exchange? If she can sell back some of her stock to her company at the market rate to pay the taxes, that’s the answer. She shouldn’t freak out; she should just do it.
@BunsenBurner This is an ISO. The company is not going public, but went through a round of funding and received a higher valuation from the venture capital backer. No plans to go public either, so a much higher valuation seems pretty arbitrary to me. The fair market value shown on her stock certificate is $2.50 and her exercise price is $0.05. Isn’t she just taxed on that? We do have a tax attorney who will advise us, but I want to understand enough to ask some thoughtful questions. These are all 20 somethings who have no clue about this stuff - scuttlebut around the office is that the valuation is going to be several times higher in the next few weeks and they’ll be taxed on the higher difference.
@Gourmetmom - her AMT FMV freezes on the date of option exercise. It does not matter if the stock price goes to $100 - if $2.50 was true per share value, then her taxable amount per share is going to be $2.45.
I also recommend getting a book Consider Your Options. It was a lifesaver for us when Mr. exercised his ISOs back in the days dinosaurs roamed the earth.
https://www.amazon.com/Consider-Your-Options-Equity-Compensation/dp/0979224896
The author also has a website with some helpful articles on equity compensation:
https://fairmark.com/compensation-stock-options/
Also, she is the owner of about half a million bucks worth of stock, for which she paid pennies. This is not a tragedy. I’m risk averse, so if it were me I’d sell all my stock back to the company and pocket my $300,000.
Well… if the company is not public yet, she cannot freely dump the stock, pay taxes, and pocket the difference. This stock likely comes with serious restrictions on the sale and most likely can only be sold back to the company. The company probably misstated the $2.50 “fair market” value… the value was likely higher if the ISO purchases happened when the new financing was already being negotiated at a higher than $2.50 per share valuation. If any new options were being offered at higher than $2.50 strike price at the time she bought her stock, likely her FMV was higher than $2.50. But I am by no means an expert in this stuff, so I strongly recommend seeking advice of a professional.
Agree with CF - of the FMV was indeed misstated, then either come up with $200k to cover the AMT and hang on to the stock or sell a part to the co. and hold onto the remaining shares. The consolation is that remaining stock would have a different cost basis for AMT purposes… and she can recover some of that AMT when she ultimately sells it (if she is subject to Amt in that year).