(For more operations resources, check out .) startup OpsMBA.com This post walks step-by-step through a case study that estimates the tax impact of exercising startup stock options. I made this for myself, so I figured I’d share. It’s long and boring, but also possibly helpful. Lawyer warning: Before you do anything, talk to a professional! This is a high-level summary to give you an idea of how the system works, not a way to calculate your . Do not rely on this to do anything! taxes I hope this is helpful to someone! Please or if you have any feedback or questions about startup law, finance, or operations. Happy to write more like this if helpful. tweet at me email me TL;DR If you just want a super quick, very rough estimate of your potential taxes, and don’t want to read this entire post (I understand!): to make a copy of the Google Doc model (you need to be logged into Google). Click here Change cells: B2, AC2, AC4, and AC5 and see the results. The Model that Sam, a startup employee living in New York City, built to estimate what her income taxes would be if she exercised her startup options in 2014. You can follow along by making a copy of the sheet and entering your own numbers. This is the model Regular Method versus AMT You pay the higher of the taxes under the regular method and the Alternative Minimum Tax (AMT) method, so you need to know your taxes under both to know which applies. The reason this is so important is that under the regular method, you probably have no tax implications of exercising your options. But if the AMT applies, you probably do, and the taxes can be high. Sam may also have to pay state and local AMT, as in and , but we’re focusing on the much larger federal tax in this post. New York California Let’s start by calculating Sam’s taxes using the regular tax method. Regular Tax Method Sam starts with her income. Her salary for 2014 is . That’s her only source of income. She enters that into cell B2 of the model. $50,000 Sam doesn’t have to pay taxes on her full income because the tax law allows . credits and deductions Sam can either figure out every deduction she has by her deductions, or she can just use the . The IRS says: “Most taxpayers have a choice of either taking a standard deduction or itemizing their deductions. If you have a choice, you can use the method that gives you the lower tax.” itemizing standard deduction So, Sam calculates both deductions to decide which to use. Itemized Deductions Sam calculates the itemized deductions first. She figures out her big itemized deductions: state and local income taxes. The government allows lots of other deductions, but those either don’t apply to Sam or are too small to affect her decision on whether to exercise her options. In columns G to H of the model, Sam uses to estimate her state and local taxes. the New York State instructions For her state and local taxes, just like her federal taxes, Sam can itemize her deductions or take the standard deduction, and choose the method that lowers her taxable income more. Sam has no substantive deductions to itemize for her state and local taxes so she’ll take the standard deduction. Page 18 of the instructions tell her the standard deduction is . $7,800 That gives her a taxable income of in cell H4. $42,200 Sam then creates the tables in columns J to T of the model to calculate her state and local taxes. In columns J to N of the model, Sam uses the formula on page 50 of to calculate her state taxes of . the instructions $2,392 In columns P to T of the model, Sam uses the formula on page 62 of to calculate her city taxes of . the instructions $1,426 also have tax tables, on pages 42 and 54, to look up your taxes if you want to double check the spreadsheet. Those instructions Using those formulas, Sam comes up with a total of in total tax due to New York State and City, which also is the itemized deduction she can take. $3,818 She now has to compare the itemized deductions total of to her to decide whether to take the itemized deductions or standard deduction. $3,818 federal standard deduction Standard Deduction Sam looks up her standard deduction in the . Sam’s standard deduction would be . table $6,200 She enters that number into cell H10. Cell H12 of the spreadsheet tells her to take the standard deduction because it’s greater than the itemized deduction of . $6,200 $3,818 Personal Exemption She can deduct one more number, her of , from her federal taxable income before calculating her taxes. personal exemption $3,950 In cell B7, Sam deducts for her personal exemption and gets a taxable income of in cell B8. $3,950 $39,850 Now that she has her taxable income, she’s ready to calculate her federal taxes. In columns V to Z of the model, Sam uses the (more detail and ), to calculate her federal taxes of in cell Z10, which the spreadsheet automatically puts in B10. (The tax tables are a few dollars more because they aren’t exact.) formula and page 81 of the tax tables here here $5,819 AMT Method Sam now has to calculate her taxes under the AMT method, so she can compare her taxes under both methods and choose the one that provides the lower tax bill. In columns D and E, Sam calculates her taxes under the AMT. Sam starts with her taxable income from the regular method, in cell E2. $39,850 The tells her to add back to that amount certain deductions from the regular tax calculation. AMT form The only deduction Sam took was the standard deduction, so she adds back that and the federal personal exemption. Sam next has to add in certain other sources of taxable income. The say that Sam must include any gain from exercising her stock options (most startups grant Incentive Stock Options, ISOs for short, because of better tax treatment than other versions), so she must add in the difference in value between the exercise price and fair market value at time of exercise. AMT instructions In columns AB to AC, Sam calculates her ISO gain. She’s vested 10,000 options, each with a current market value of $5 and an exercise price of $1. (You should be able to ask your company for each of those numbers.) She multiplies the 10,000 options times the difference in price of $4 to get . $40,000 That income automatically populates cell E10 as the ISO exercise spread. That gives her an income of for the AMT method. $90,000 In columns AE to AF, Sam then calculates her AMT exemption, using the form on page 9 of . the instructions As the note at the top of the form says, if Sam’s income were at least $328,500, she’d receive no exemption. Sam’s income isn’t that high, so she continues with the calculation in columns AE to AF. That exemption amount automatically goes into cell E12. She now has all the inputs to figure out that her taxable income under the AMT is . $37,200 Sam’s ready to figure out her taxes under the AMT method using the formula on line 63 of the . In IRS language: “If line 36 is $182,500 or less ($91,250 or less if married filing separately), multiply line 36 by 26% (.26). Otherwise, multiply line 36 by 28% (.28) and subtract $3,650 ($1,825 if married filing separately) from the result.” IRS AMT form Using this formula in cell E15, Sam estimates her federal taxes under the AMT calculation to be . $9,672 That compares to under the regular method. You can see the difference of in cell B18. So, if she exercise, she’ll be stuck paying the higher AMT tax amount. $5,819 $3,853 Make a Decision She can now decide whether to exercise her options. If she has the extra money to pay the taxes (and can cover the exercise cost, which would be the exercise price of $1 times the number of options 10,000 if she wants to exercise all of them, so that’s a lot of money!), she may want to do it. The two main benefits of exercising sooner are: Starting the clock on long-term capital gains tax rates which are lower than regular income tax rates. The AMT impact becomes even greater as the company’s valuation rises. As cell AC4 in the model goes up and the exercise price remains the same, the taxable income from the options goes up. The valuation could also drop, even to zero, so exercising is a risk! AMT Credits Sam also may get future tax credits for paying the AMT. So, that difference between the tax paid under the AMT and regular methods might come back to her over time. Like the AMT itself, the law around AMT credits is complicated and unpredictable. Here are a few articles explaining it (notice the dates on these, and make sure they’re up to date): , , . SmartMoney Fairmark MyStockOptions Be Careful! In conclusion, when deciding whether to exercise your options. You might end up with a tax bill and no cash to pay it! Seek professional assistance, and do your own research! BE CAREFUL Hope this was helpful to someone! Please if you have any comments, I’d love to hear them and improve this if you have feedback. tweet at me If you’re also interesting in figuring out the value of your startup options, might help. this other blog post (For more startup operations resources, check out .) OpsMBA.com disclaim.in
