When someone with startup equity starts thinking about exercising their options, the first question is almost always about taxes. That’s understandable (the horror stories about surprise AMT bills are real), but in my experience, tax is rarely the right place to start.
Exercising options typically means writing a check to buy stock in a company. That decision touches your investment philosophy, cash-flow needs, and tax bill. Getting the tax planning perfect on an exercise you shouldn’t have made doesn’t help you. So before running any tax projections, I think there are at least four big questions worth answering, and only one of them is about tax.
Throughout this series I’ll use a running example: say you hold 10,000 incentive stock options (ISOs) with a $10 strike price, and the company’s latest 409A valuation puts the shares at $110. The numbers are illustrative, but they’re representative of the kind of position where these decisions start to carry real money.
How bullish are you, really?
- Concentration risk: Your paycheck and your healthcare already depend on this company. Exercising options converts your cash into more exposure to the same company. If the company stumbles, you can lose your job and your investment at the same time. That’s a level of concentration most people would never accept in their brokerage account, and it deserves candid scrutiny before adding to it.
- The portfolio view: An exercise doesn’t happen in a vacuum. In the running example, buying all 10,000 shares costs $100,000 at the strike price alone. For some portfolios that’s a measured position; for others it’s most of their liquid net worth. Same exercise, very different decision.
- Private stock is illiquid: Public stock can be sold tomorrow if your thesis changes. Private shares generally can’t. Whatever cash goes into a private exercise should be cash you can live without for years, because that’s how long it can take to see a sale window.
There’s no tax strategy that rescues an investment you didn’t believe in. If you wouldn’t buy this stock with fresh cash at the current price, that’s worth sitting with before anything else.
Do you have the cash?
- The strike price: The headline number. In our example, $100,000 to exercise in full. Partial exercises are allowed (and common), so this is a dial, not a switch.
- The tax bill: Exercising ISOs can trigger the Alternative Minimum Tax even though there’s no income on a paystub. Exercising NSOs can require you to fund payroll tax withholdings in addition to the exercise costs. The mechanics deserve their own article (that’s Part 2 of this series), but the short version is that a large exercise can create a five- or six-figure tax bill payable the following April, out of pocket.
- The other stuff: Emergency fund, planned purchases, other tax payments. An exercise that fits on paper but empties your accounts creates pressure to sell at the first opportunity, which can undo the tax benefits the exercise was supposed to capture.
What’s your timeline?
- Staying or going: Most ISOs must be exercised within 90 days of leaving the company, or they convert to less favorable treatment or expire outright. If a departure is plausible in the next year or two, that window becomes part of the math. Leaving can force the exercise decision on a deadline, at whatever the tax picture looks like that year.
- Vesting status: Some plans allow early exercise of unvested options. That opens planning opportunities (including an 83(b) election that requires careful handling), but it also means paying today for shares that are only earned by staying.
- Liquidity on the horizon: If the company is signaling a tender offer, acquisition, or IPO, timing starts to matter a great deal. Shares must exist before they can be sold, and the tax character of a sale depends on how long the shares were held after exercise. Part 3 of this series covers exactly this.
What does the tax picture look like?
This question comes last on purpose. Once the first three have answers, the tax planning comes into play: the spread between a $10 strike and a $110 valuation is $100 per share, and how and when that spread gets taxed varies enormously based on decisions that are entirely within your control. Exercises can be sized and timed to reduce or eliminate AMT. Holding periods can convert ordinary income into long-term capital gains. Sales can be structured to fund their own tax bills.
All of that is the subject of the rest of this series. But it works best as the final layer of the decision, not the first.
Where this goes next
- Part 2 covers ISO taxation and the AMT: why exercising can create a tax bill with no cash to show for it, and how modeling an exercise against your full-year income can identify the number of options that can be exercised with no AMT at all.
- Part 3 covers selling: tender offers, disqualifying dispositions, and what the holding-period rules (including QSBS) actually reward.
- Part 4 covers non-qualified options: why they show up alongside ISOs, what exercising them really costs, and how they can be used to expand the AMT-free exercise capacity from Part 2.
None of these decisions need to be made in a day, and most of them benefit from being modeled against your actual income, cash position, and plans rather than reasoned out in the abstract. A tax advisor who works with equity compensation can turn “it depends” into specific numbers for your situation.
This article is for educational purposes only and is not tax, legal, or investment advice. The scenarios and numbers are illustrative and don't describe any actual client. Tax outcomes depend heavily on individual circumstances; consult a qualified tax professional about your specific situation.