At a liquidity event such as an M&A, unexercised stock option grants are typically cashed out for a value equal to the spread between the exercise price and the liquidity price per share net to common stockholders. When the company executes such a payout, it is considered a compensation event and subject to payroll taxes. This includes both the employee’s medicare tax and the employer’s payroll taxes. However, if the ISO grant is exercised before the M&A event then the final profits are either a disqualifying disposition or a capital gains event depending on how much time has elapsed between the exercise and the M&A event. Nevertheless, both cases are investment income related and will not be subject to the 3.8% Net Investment Interest Tax. The exception being very high income individuals where the surtax is reinstated on investment income.
Something similar is true if you hold Non-qualified Stock Option grants (NSOs). You’ll pay medicare taxes on the spread between your exercise price and the FMV at the time of your exercise, but the final gain between the FMV and ultimate exit price is considered a capital gain. That is generally not subject to medicare taxes except for the surtax and to the extent that it places you in a higher tax bracket. If it turns out to be a long term capital gain, then there will be additional savings.
If you hold employee stock options or restricted shares in a private company funded by institutional venture capital, feel free to contact us at the Employee Stock Option Fund for more information on how we can assist you with a non-recourse cash advance. By doing so, you can not only avoid the risks associated with investing directly in a startup but possibly improve your taxes as well. For specific tax related support related to stock option exercises, please contact Scott Chou.