The timing of exercising stock options can vary from person to person and depends on whether your options are non-qualified (NQSO) or incentive stock options (ISOs). ISOs can only be granted to employees, unlike NQSOs that can be granted to anyone (i.e. contractors, employees, and directors).
There are tax nuances between the two types of options when the options are exercised. For NQSOs the spread between the fair market value and the exercise price on the day the options are exercised is taxed the same as salaries, using the exerciser’s personal income tax rate plus social security and medicare tax.
ISOs are not taxed on the exercise date and will be taxed as capital gains if the options are sold two years after the grant date and one year after the exercise date, but could be subject to AMT if the taxpayer is in a higher tax bracket. If ISOs are sold early the options will be treated the same as NQSOs for tax purposes.
If your options are NQSOs the cons to exercising the options early are (i) the current tax implications, (ii) paying for the options, and (iii) the risk of stock plummeting. When the stock options are exercised you will be taxed at your federal and state income rates plus salary and wages taxes (e.g. social security and medicare taxes) on the difference in the spread of the exercise price and the fair market value of the shares purchased. That being said, if the options are exercised early there may not be much difference between the exercise price and the fair market value. The second con is having the cash to pay for the options. If you have to take out a loan to pay for the stock options then you are in a losing situations. We suggest reaching out to your accountant or contacting us to run an analysis to determine if it is in your favor to take on debt to sell your options. Also, there are marketplaces to sell your stock (e.g. EquityBee) if you do not have the money to exercise. The third implication is if you exercise your options when there is a large spread, increasing the potential risk of paying higher taxes on the current upside of the company’s stock with increased risk of value decreation from holding the stock long-term.
All the above factors have to be taken into when determining when to exercise or sell your options. Some of the tax headwinds above can be eroded if you can take advantage of the section 1202 QSBS qualification.
If the options are ISOs they will not have the current unfavorable tax implications that NQSOs will. Exercising options early is up to the discretion of the holder, but there is tax modeling that can be helpful when forecasting the ROI of the time of exercising your options. Reach out to QSBS Expert for help with maximizing the value of your options.
Click here for more on whether stock options qualify for QSBS.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.