Lisa: The tax consequences vary depending on the type of option that the employee holds and can be pretty complex. At a high level, if she holds the stock options until an exit and immediately exercises and sells the stock, either in the public market or to the buyer in an M&A transaction, she’ll owe tax on the difference between the value of the stock and her exercise price. She’ll be taxed at a rate equal to her ordinary income tax rate on the entire sale, which means a higher tax obligation for her.
On the other hand, if she exercised her stock options before the exit, she may be able to pay lower taxes if all goes as she hopes. If the value of the stock is greater than her exercise price when she exercises, she may owe tax on that gain, depending on the type of option she holds and her own personal tax circumstances. Then, if she satisfies certain holding periods, which vary depending on the type of option, when the shares are ultimately sold she’ll be taxed at the long-term capital gains rate. If the value of the stock increased over time and she was able to sell at a gain, this all means an overall lower tax obligation for her.
By exercising and trying to pay less in taxes and ultimately make more money, the employee is taking on risk though. If things don’t go as she hopes, she may lose some or all of the money she pays to exercise, including taxes, so anyone thinking of exercising should dive deeper into the tax consequences of his or her options specifically, the company’s prospects and his or her own financial situation before exercising.
I should also add that tax laws are always subject to change – as I’m sure you know, they changed quite a lot in recent years – so the tax rates or even the overall structure I just described could change in the future, but that’s the state of play now.
Ward: As Lisa said, the IRS taxes you when you exercise. That can be a big pain in the neck at really highly valued companies. Let’s say they had options for 10,000 shares at a dollar a share. Maybe an employee could come up with $10,000 to buy his stock. What he couldn’t do is come up with the money to pay the taxes on $4 million worth of income if the company has shot up in value and is now worth 400 times what it was when his option was granted.