Because the options, when they vest, have no value. However, an ITM option does have value. The amount it's ITM. So you'd have to pay the amount it's below FMV as income, right?
I think the parent poster is saying that this tax treatment of options is inconsistent with the way RSUs are taxed, though.
RSUs are taxed at vest time even if you hold the shares, presumably because they can be sold immediately since they have some FMV.
Options are not taxed at vest time, even if they are ITM and have some large positive FMV. And for ISOs, even if you exercise immediately at vest and you don't sell the exercised shares, there is no tax (assuming no AMT).
What is the reason for the different tax treatment?
An option itself has fair market value. Like, I can buy options on Uber stock right now at a variety of price points. You can make the case that options at FMV have negligible value, which is why they get special treatment. But if you want to work at a startup unicorn and ask for stock options with a strike price of $0.01 as your whole income, it's still (possibly) extremely valuable.
This is going to sound mean but the more you talk the more confused I am about your original point. Please understand, I am trying to understand you.
You originally said:
> options being cheaper to purchase means a larger tax bill when you vest them
The operative word here is vest. No tax on vest.
I think you are trying to say "if you join a startup and get dirt cheap options, when you exercise them at a later date and they are worth something then, your tax bill will be larger than if you got more expensive options and exercise them. Yes, this is true.
- strike price: $0.01 FMV at exercise: $20
- strike price: $15.00 FMV at exercise: $20
You have a larger gain in the first, so sure, you will pay more tax. Is this what you are trying to say?
If you give me something of value (stock, steaks, money) in return for work I owe taxes on it. As I understand it, I owe taxes when such an item (eg RSUs) become something I can acquire and control, aka vest.
I can go online right now and buy options in Uber (or any other publicly traded company). Options clearly have some value.
Options in a private company with a strike price of FMV have essentially no value, and have no taxes.
Options in a private company with a strike price of $0.01 and a FMV (per share) of $20.00 are worth at least $19.99.
Therefore, options with a very low strike price should create a taxable event when they vest, whereas options with a FMV strike price would create a taxable event of $0 when they vest.
So a very low strike price seems to force employees to pay taxes when they vest.
It's possible I'm wrong (I'm not a tax accountant or attorney), but I would like the problem in my logic pointed out.
Thank you for clarifying. You are a bit wrong, and I'm not a tax accountant, but speaking from experience as someone who has had options that have vested and exercised in startups, and have paid taxes on them. I appreciate you engaging with me and I'm trying to help you.
If you buy an option right now in uber, you will not be taxed until you exercise that option (I'm 99% sure of this -- I don't trade options, but also I think you can buy/sell options contracts themselves, and I don't know the tax implications of that) You will either have a capital gain, or a capital loss. An option is the right to buy/sell a stock at a price. You don't get taxed until the moment you actually buy/sell the asset.
When you are given options in a startup they work the same way, it's just a contract, you will have no tax implications until you actually receive something of value, by exercising the right to purchase the stock.
> So a very low strike price seems to force employees to pay taxes when they vest.
People don't pay taxes when the options vest, because that's just a part of a contract. People pay taxes when they exercise the right to purchase those options which converts them into shares. If your equity is worth 100,000 FMV and your strike price for those options equals 10k and you do nothing, you have no tax. If you execute that contract, you pay 10k, get 100k worth of stock, and have a 90k gain. That's what you are taxed on.
This is what forces people in startups to pay taxes and the dangerous part is you might pay taxes and never get a chance to sell the stock.
I'll share two examples:
- I've exercised options where the strike price == FMV, and paid no tax. But the operative word you keep mixing up is vesting and exercising.
- I also currently have options that are vesting in 10 days, and I will not pay tax until I exercise them.
RSUs are different, because they are literally actually stock, it's not a contract to buy stock, so you are given an asset, and you are taxed appropriately for it as you had a capital gain. (The same as the second half of an options contract, you get stock, you are taxed on the value that you get)
> If you buy an option right now in uber, you will not be taxed until you exercise that option
This is true (or sell the option). This is just like stock, in that it only gets taxed when it pays off, either by a dividend, buyback or sale. Only in this case, it's when it gets executed or sold. (Although I think if you execute and hold the stock, it just somehow adds to the basis.)
> People don't pay taxes when the options vest, because that's just a part of a contract
I agree that ATM options have this. My contention is that ITM options (ones with a strike price less than FMV) would require taxes. I could easily be wrong, but my assumption would be since options have a FMV themselves (just like shares of stock), they would be income in and of themselves.
Maybe I'm incorrect in that reasoning, but I don't understand why. An option to buy a share of Uber is currently ~31.68. An option to buy a share of Uber for $20 is ~11.90. Therefore, if you buy that option and sell it later for 12.00, you'd have a short term capital gain of 0.10. If I give you an option, I'm giving you a gift of $11.90.
My confusion is how can a company give you, say 100,000 options, which could have a market value in the millions and you don't pay tax on them.
Appreciate your final question here and I wasn't able to answer "why" but this document on page 12 https://www.irs.gov/pub/irs-pdf/p525.pdf explains that you won't pay tax on ISOs at grant. Wish there was a git blame on the file :P
I have to assume that if someone was granted a million dollars worth of gains in one year and the asset was not sellable the tax burden would probably bankrupt most people. (This is the risk of exercising options when the stock is not yet liquid anyway, "phantom tax").
Thanks for the link, that clarifies things so much. I had been circling around the "non-statutory options" on page 11, like you would get without the 90 day exercise clause. In that case, the taxable event is vesting (assuming the options can have a determined FMV). I see that I was confused by thinking FMV exercise price was part of the requirement to have an ISO, but instead the IRS clarifies in the middle of page 13 that any valuation below FMV is taxable on exercise (if it's an ISO, and not a nonstatutory option)
