So you join a shiny new "start up" and they offer you some stock options as part of their compensation package. This is typically done to improve compensation without requiring additional liquidity which is typically a limited resource for a start up.
These "ISOs" (Incentive Stock Options) are usually option agreements where the company agrees to let you "purchase" shares of the company in the future at a strike price equal to current valuation. So even if you "exercise" (purchase) the stock 2+ years later you pay the same price you would have if you had purchased the stock on your first day at the company.
The problem with tax here is that in those 2+ years before exercising your "options" your company may have grown/raised more money with greater valuations...so the value of the stock may have doubled, tripled, or increased in even greater value. Well lucky you! According to your ISO you can purchase the stock for the value it was worth 2+ years ago!
"Hold on just a minute," the IRS says, if you purchase a share for $5 that is "valued" at $25 now...what you actually have is an immediate realized gain of $20. Since you spent $5 and acquired an asset worth $25...you should be taxed AMT on the realized gain of $20. Makes sense.
The issue is with "valued" here. In the case of pre-IPO startups the stock you purchased cannot really be sold. Value of a pre-IPO company's stock is more or less correlated to what investors agreed to in your last round of funding (e.g. I <insert_investor_here> agree to give your company $XXXXXXXX for YY% of your company). But at the end of the day, you pay $5 for a piece of paper that says you have stock in a company that is estimated to have the value of $25...but isn't actually worth anything since you can't actually turn it into money. You can't sell that piece of paper for $25 (in fact, you can't sell that paper at all).
Which means you end up owing taxes on a $20 realized gain on an asset you can't sell. That is, you can't turn around and sell some of that newly acquired stock to pay your tax...again it's not really worth anything...it's estimated value is just higher than what you paid for it.
So the question is...where do you come up with the money to pay this tax? Well, in the case of these individuals, you go into debt.
One could view the AMT as explicitly serving as a way to prevent poor/middle class people from becoming wealthy by way of stock options.
Edit: FTR I think just taxing on sale for the entire realized gain would make sense to me as well...but I imagine this policy is to try and prevent high income individuals from dodging income tax by taking all their compensation in stock.
This is a massive issue in this era of companies which never allow their stock to freely circulate, and mostly is based on the previous eras in which a startup that granted options would actually go public at some point and allow the holders of the options to sell their stock for money.
why can't the tax be levied when the same stock is liquidated into cash? then you'd get a real price, rather than an estimate.
> Under current tax law, the income from exercising ISOs, a special type of option typically reserved for executives and senior employees, falls under an alternative tax calculation designed to prevent high-earners from using deductions to avoid paying tax. Non-qualified stock options, more commonly awarded to regular employees, are taxed the year they’re exercised on the gain in the stock.
Maybe it's a common knowledge amongst the Silicon Valley engineers, but for those of us who are not in startup, could someone please explain how this is possible? Specifically, in what logic would you owe more tax to exercise the option(which amounts to purchasing at this point) for half the amount of tax you'll pay? How does purchasing something of $X force you to pay $2X in taxes? I've combed through this thread for answers and it seems like a commonly understood problem.