Capital gains represent the growth in an asset’s value — and are taxed when the asset is sold.
Whether or not the capital gains are considered long-term or short-term depends on how long you have held the asset and that will affect how much you pay in taxes.
Long-term capital gains usually have more favorable tax rates.
Starting the clock
If there is one acronym you may learn to love when it comes to taxes it may well be: LTCG. This stands for long-term capital gains and is — for many people — a rate that is less than your ordinary income tax. This is hopefully what you’ll also qualify for when or if it comes time to sell your startup shares. (And remember, always consult with your tax advisor. And call your mom just to be nice, but we digress.)
Let us explain: You typically only pay capital gains when you sell your shares (or any other asset). You won’t pay capital gains when you exercise your stock options. However — and this is important — the date on which you receive your stock options and the date on which you exercise them both factor into whether or not you’ll owe short- or long-term capital gains.
👉 The date on which you receive your stock options and the date on which you exercise them both factor into whether or not you’ll owe short- or long-term capital gains.
Keep reading for more insight into what capital gains are, how they can affect the taxes you pay, and where your employee equity comes into play.
🤓 Lawyer Pete made us do it: This article is for general informational purposes only (and we have a couple of additional disclaimers you should keep in mind, posted at the end of this piece). If you have questions about your specific financial situation, you should speak with a professional advisor.
How capital gains taxes work
Before we can explain how capital gains can affect your taxes when exercising stock options, it is helpful to have a better understanding of how capital gains work and why this classification is so important.
The term itself, capital gains, is used to describe the increase in an asset's value once the asset is sold. For example, if you bought Stock A for $10 and you sold it for $15 – the capital gains are the $5 difference.
Whether the sale of an asset is considered to be a long-term or short-term capital gain can have a big impact on how much you pay in taxes on any income earned from the sale.
Short-term capital gains (holding the asset for one year or less before selling) are taxed at your ordinary-income rate. And typically the ordinary income tax rate is higher than your long-term capital gains rate.
For long-term capital gains (assets sold after being held for more than a year), the tax rate can either be 0%, 15%, or 20% depending on your tax bracket in the year you sell the assets.
The type of stock options you own may affect how you pay taxes and how long you need to own your stock options before they can be considered long-term capital gains.
ISOs and capital gains
With ISOs, exercising is not considered a taxable event. However, since you may likely qualify for the alternative minimum tax (AMT), there will likely be a tax bill of some kind. Once you have converted ISOs into shares and sold those shares, only then will you need to pay capital gains tax.
If you hold the shares for a year or less, you’ll have short-term capital gains and will pay the ordinary tax rate. To secure a long-term capital gain, you must hold the ISOs you plan to sell for two years after the date you were granted the stock and at least one year past the exercise date.
When do you owe capital gains on ISOs?
NSOs and capital gains
Non-qualified stock options (NSOs) can be granted to employees as well as consultants and advisors, whereas incentive stock options (ISOs) can only be granted to employees.
With an NSO, you will incur a tax bill as soon as you exercise the option, and the difference between the fair market value (FMV) of the shares and the strike price will face an ordinary income tax that year. You will also be taxed when you sell your shares. Any further increase beyond the price when you exercised your shares will be subject to capital gains tax. How long you wait to sell those shares is what will determine if you pay the short-term or long-term capital gains tax rate.
When do you owe capital gains on NSOs?
At the end of the day, life is life. You may not always be able to wait the required period of time to optimize for long-term capital gains. But if you have the choice to wait it out, qualifying for the lower tax rate will save you money. Do what is best for you!
This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for investment, tax, legal, accounting, or other professional advice. Vested does not provide investment, tax, legal, accounting, or other professional advice. You should consult your own investment, tax, legal, accounting, or other professional advisors before engaging in any transaction or equity decision.