Possible Tax Planning Opportunity for Startupers with Vested Stock Options

Should you exercise the vested portion of your stock options before the end of this year, to get the maximum potential tax benefit from the temporary 100% exclusion of capital gains on the later sale of Qualified Small Business Stock?

That question was a mouthful! The issues are complicated enough to require background on terminology and explication of the rules. If this topic interests you, be sure to read Joe Wallin’s recent post on how the rules work and how recent federal legislation enhances potential tax benefits, but only for transactions that occur before the end of this year.

Most of what you read about this planning opportunity will frame it as a benefit for angel investors, as well as for startups looking to close on financings by the end of this year. But some creative lawyers and accountants are noting that the rules should be able to be utilized by stock option holders, too, to the extent that they exercise options to purchase stock that otherwise meets the legal criteria.

Deciding to exercise a stock option prior to a liquidity event or when otherwise lacking a market for the relevant company’s shares is always risky. I know one guy who always exercises his options as they vest, in order to optimize the possibility he will receive capital gains treatment on liquidity or other disposition of his shares. People so inclined to make that tradeoff – paying real cash now for stock that may end up never being liquid or gaining in value – probably have every reason to strongly consider exercising any “backlog” of vesting by the end of this year, if they would otherwise be inclined to make the investment.

Even if you exercise now and even if all of the other necessary criteria are met, you don’t get the extra (or the normal) benefit of excluding gains on Qualified Small Business Stock unless you hold the stock for five years. Most of us, the koolaid we’re drinking is flavored to lead us to believe we ain’t going to be around in a deal for five years. So maybe this planning opportunity is for those who can permit themselves to contemplate that they may working a longer runway, may be in it for the long haul, or may just be doing some “downside” planning.

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