I am back home at my parent’s house for a few days. Although my apartment is only about a 25 minute drive on the other side of the city, I think there’s something really therapeutic about coming “home”. So I packed up a bag and my cat and had my dad pick me up. Never too old to get picked up by your parents.
Last night, I spent a lot of time reading this tweet thread by Eric Paley about stock options. The series of tweets focuses on better communicating stock option packages to current and future employees. I agree with the message Eric is sending here.
At Secfi, we focus on helping employees maximize the value of their equity compensation. I spend my day to day speaking and advising clients and I can say that stock options are brutally confusing.
Explaining the implications of options in an upside scenario is relatively straight forward. If everything goes well, you want to exercise as early as possible to maximize your equity.
The hard part of course is what happens when things don’t go as well as planned. From a tax perspective, this can lead to a disastrous situation. A simplified example below:
Let’s say an employee joins a start-up and is granted stock options in year 1. The options begin to vest in year 2 and the company is on a great growth trajectory. Everything is going well and the employee’s stock option package has appreciated significantly.
In year 3, an employee decides to pony up the cash to exercise their option grant so they can save on taxes and take more home in the future. Although the strike price is low, the employee is likely going to pay a pretty penny in alternative minimum tax due to the increased 409A due to growth of the company.
Year 5 and things are headed south. The company goes bankrupt and the employee’s shares are worthless. The employee has lost the money paid to the company for the exercise cost. In addition, the employee has paid taxes on the appreciation of the stock. The cash received back for the shares is zilch so employee is in the hole all that cash.
Logically, you might think that the employee will at least have some tax relief here. An employee paid taxes on an artificial gain and received nothing back which means they’re at a loss. Not so fast.
Due to the complicated AMT loss limitations, the employee’s tax benefit is going to be severely limited. That AMT the employee paid may be recovered in the future, but depending on how the numbers shake out, this could take many years sometimes beyond one’s foreseeable lifetime.
This is the nightmare scenario with stock options. An employee pays money out of pocket to exercise the options and pay taxes, receives nothing back for the stock, and then is only able to recover the tax paid over the course of many years.
This was such a big issue that Congress enacted the American Taxpayer Relief Act of 2012 so those in these situations would be able to recover those taxes paid instantly. Unfortunately, those regulations still allow for this nightmare scenario to happen today although the Trump Tax Cuts did reduce this AMT burden.
Unfortunately for employers and employees, this is one of the harsh realities of stock options and something that is not easily explained and therefore quite often overlook.
