Exercise NSOs Earlier

Exercise NSOs sooner vs later to shift taxation from (higher) income taxes to (lower) long-term capital gains tax rates

Strategy Overview

The goal of this strategy is to reduce your overall tax bill by optimizing when you exercise your NSOs. Doing so will help shift a greater portion of the taxes on gains in the share price from (higher) income taxes to (lower) long-term capital gains tax rates.

Tax Details

When you exercise a NSO, the difference between the grant price and the current fair market value (FMV) is taxed as ordinary income. As the FMV of the company increases, so does your tax bill at ordinary income rates.

But if you purchase shares and hold them for more than a year, any additional increase in value is taxed at (lower) long-term capital gains rates instead of (higher) ordinary income rates. There are risks, but if you have strong confidence in your company, this strategy may help you reduce your overall tax bill on additional gains by 12–15.5%. For additional info: 🔗NSO Stock Options; 🔗NSO Taxation

Key Benefits

• A lower overall tax burden if the company value increases, assuming the stock is held for at least 1 year. On average, individuals typically have a 12% to 15.5% lower total tax rate on additional future increases in value.

• Increased flexibility if you leave the company since you own shares vs. having vested options.

• Starts long-term capital gains holding period clock sooner, as well as starting the clock on QSBS qualification (if applicable).

Key Considerations/Flags

• Significant investment risk exists; if the company fails or the valuation declines.

• Shares are likely to be illiquid for years before a liquidity event occurs (if one even ever does).

• The upfront cost to purchase shares and potential tax liability can be significant.

Strategy: When to Consider This and When to Avoid It

🟢 When to Consider This Strategy:

• You have cash to purchase shares and strongly believe in the company's prospects.

• You may leave the company soon and want to exercise vested options before departure and anticipate the 409a valuation may increase in the near or medium term.

• [Potentially] If your company is anticipating an IPO soon. The fair market value of the company becomes the publicly traded stock price post-IPO. Private company 409a valuations are typically much lower than the IPO valuation.

🔴 When to Not Use This Strategy:

• You have low conviction in the company's business potential.

• You don't have the funds and/or need cash for other personal financial goals.

🟡 Consider on a Case by Case Basis:

• You don't have very high conviction in the company's business potential.

• The total cost of exercising and paying taxes would be financially difficult for you.

• You plan to stay at the company long-term and a liquidity event is not in sight.

• You believe the 409a valuation may stay flat or decrease at the next round (in which case waiting likely makes sense).

Exercising NSOs is first and foremost an investment decision. Tax optimization is important but should be your secondary consideration.

Example