If you’re a startup employee, chances are you earn stock options or grants as part of your compensation package. It’s a popular employee retention tactic, and one that, if done right, can be an excellent catalyst for generating significant wealth. But what happens when you switch jobs, either on your own accord or from a layoff or termination? Do you get to keep all your equity, or will you have to leave it all on the table? And if you get to keep it, what will it cost you? In this article, we’ll go into all that and more, including:
- Vesting schedules and cliffs
- Alternative Minimum Tax
- The Post-Termination Exercise Period
- State residency considerations for relocation
Vesting schedules and cliffs
A vesting schedule is the timeline of when you will receive your stock options or grants. Startups typically follow a three to four year vesting schedule, with shares gradually being distributed monthly after one full year on the job (that one-year mark is known as the cliff). So it should go without saying that if you leave your job before the conclusion of your vesting schedule, you will have to accept the reality of not taking all of your equity with you, if any equity at all.
If you do have vested options at the time of your departure, you’ll have to decide whether or not you’d like to exercise (aka, buy) them. If you were granted stock in the form of Restricted Stock Units (RSUs), there’s no decision to make about whether or not to buy them. But options, most commonly issued as Incentive Stock Options (ISOs), are more complicated. When exercised, they can often trigger something called Alternative Minimum Tax (AMT).
Alternative Minimum Tax (AMT)
You’ve probably heard this story before: an eager startup employee who just went through an IPO has decided to exercise their options and buy the stock for a hefty gain. They haven’t sold their stock yet, but the IRS still sees that as income, and they will tax that employee the delta of the exercised price and the strike price, a figure known as the bargain element. For many, this can be a devastating scenario that can result in hundreds of thousands of dollars in tax liabilities.
But AMT wasn’t meant to penalize startup employees for years of hard work. The US government introduced the Alternative Minimum Tax (AMT) in 1969 as a control mechanism to ensure high-income individuals pay their fair share after finding too many who took advantage of tax loopholes to pay no taxes at all.
Exercising your options will come at a cost—there’s no avoiding that. And it’s important to remember that you will be left with an illiquid asset. Curious about what you might owe in AMT from exercising your options? The Harness Wealth Equity Tax Insights tool will run those numbers for you.
There are many ways to properly manage and mitigate Alternative Minimum Tax when it comes to ISOs, starting with understanding the best time to exercise your options. Exercise your options early, and you may be entitled to considerable tax advantages. Wait too long, and your options may be gone forever…
The Post-Termination Exercise Period
The Post-Termination Exercise Period (PTEP) is the amount of time you have to exercise your options after leaving your job. The PTEP duration can be anywhere from thirty days to ten years, so it’s important to carefully review the terms of your equity agreement or contact your HR department. Separate from the PTEP, the IRS has rules of its own: If you exercise your ISOs more than 90 days after leaving your job, they will be taxed as Non-Qualified Stock Options (NSOs), which generally carry fewer tax advantages.
State tax considerations for relocating employees
Lastly, if relocation is in the cards for your job switch plan, many US states offer favorable tax structures. As of 2023, there are nine US states that do not impose state income tax, and seven of these states also lack taxes on investment income, making them ideal locations for startup equity holders or crypto investors. Two of those states, Texas and Florida, have become incredibly popular in recent years among startup employees for their warm weather, rapidly-growing cities, and overall high quality of life.
Work with a Harness Tax Advisor
Switching jobs can be an exciting change, but it’s important to pay close attention to the financial changes it could bring to your life. If you have startup equity and need professional advice on how to best manage it, consider booking a 1-on-1 Equity Tax Planning Session with an equity-experienced Harness Tax Advisor today.
Tax services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is an internet investment adviser registered with the Securities and Exchange Commission (“SEC”). Harness Wealth Advisers’ registration as an investment adviser with the SEC should not imply a certain level of skill or training.