Exercise Stock Options After Leaving a Startup: The 90-Day Window

What happens to stock options when you leave a startup?

Two separate clocks start on your last day. Your option plan and grant agreement set the deadline to exercise at all, and say what happens to options left unexercised. Tax law sets a second limit: an incentive stock option (ISO) keeps ISO treatment only if you exercise it within 3 months after you stop being an employee, or 1 year if you left because of permanent and total disability (26 U.S.C. 422(a)(2) and (c)(6); 26 CFR 1.422-1(a)).

The spread is the share value on the exercise date minus the exercise price you pay.

A case is not simple when the company offers to extend your window (that can end ISO status), when the spread is large enough to bring alternative minimum tax (AMT) on shares you cannot sell, when the window crosses December 31, or when you lived or worked in Canada or another state during vesting. Gather the plan, each grant agreement, your termination date in writing, the latest share value from the company, and any amendment or extension offer.

Is the 90-day window the same as the ISO 3-month rule?

No. The window in your grant is a contract term; the 3-month limit is a tax rule, and they may not match. The ISO test counts months, not days: you must have been an employee at all times until the day 3 months before you exercise. With a June 30 last day, an exercise on September 30 meets the test and one on October 1 does not (26 CFR 1.422-1(a)(1)).

• Plan window shorter than 3 months: the plan deadline controls; after it, there is nothing left to exercise.
• Plan window longer than 3 months: you can still exercise later, but those ISOs are taxed as nonstatutory options (NSOs) (Publication 525).
• Staying on as a consultant or advisor: the ISO clock follows your status as a common-law employee, not your involvement with the company (26 CFR 1.421-1(h)).
• Leave of absence: employment is treated as continuing for up to 3 months of bona fide leave, or longer if a statute or contract guarantees your return (26 CFR 1.421-1(h)(2)).

NSOs have no tax deadline at all; only the plan's deadline matters for them.

What happens to ISOs exercised more than 3 months after leaving?

An ISO exercised after the 3-month limit is taxed as an NSO. Publication 525 says that if you don't meet the employment requirement, your option is a nonstatutory stock option. The spread on the exercise date becomes wages from your former employer, as described below.

What tax do you owe on ISOs exercised inside the window?

ISOs exercised within 3 months of your last day owe no regular income tax at exercise. For AMT, though, the spread is an adjustment on Form 6251, line 2i, which can create AMT in the exercise year even though you received no cash (Instructions for Form 6251; Publication 525). No Social Security or Medicare tax applies to an ISO exercise (Publication 15-B).

If your vesting speeds up when you leave, the options that vest early count toward the yearly ISO dollar limit for the year of the speed-up, so part of them may be NSOs (26 CFR 1.422-4(b)(4)); the limit is explained in exercising startup stock options.

The company sends Form 3921 showing the exercise price, the value on the exercise date and the number of shares. Keep it: your AMT basis in the shares differs from your regular basis. How much spread fits before AMT starts, and what changed for exercises from this year, is covered in AMT on incentive stock options. Holding periods and the tax when you sell are in exercising startup stock options.

What tax do you owe on NSOs exercised after you leave?

The NSO spread is ordinary income in the year you exercise, even after you have left (26 CFR 1.83-7). It is wages from your former employer, reported on a Form W-2 in boxes 1, 3 and 5, with the spread shown in box 12 under code V (Instructions for Forms W-2 and W-3).

Because it is wages, the former employer generally withholds:

Sources: Publication 15 and Publication 15-B. The flat rate is only withholding; if your actual rate is higher, the rest is due with your return, and an estimated payment may be needed, as explained in exercising startup stock options. State income tax may also apply; if you have moved, see moving to another state before selling startup shares.

The company offered to extend my exercise window: are my ISOs still ISOs?

Possibly not, and you may lose ISO status the day the extension is made. An extension of the exercise period after termination is a modification, and a modification is treated as granting a new option, whether or not you ever use the extra time (26 U.S.C. 424(h); 26 CFR 1.424-1(e)).

The new option is an ISO only if it meets every ISO requirement on the modification date, including:

• Exercise price: at least the share value on the modification date (26 U.S.C. 422(b)(4)). If the shares have risen above your price, the new option cannot be an ISO.
• Employee status: you must be an employee when an option is granted (26 CFR 1.421-1(h)), so an extension made after you leave is a grant to a non-employee.
• The 3-month rule still applies: any exercise more than 3 months after you leave is an NSO exercise, whatever the extended window says.

An offer to change your option that stays open 30 days or more is a modification as of the date the offer is made, even if you decline it; an offer open less than 30 days changes the option only if the change is made (26 CFR 1.424-1(e)(4)(iii)). Before accepting, check whether the extension covers all your options or only those you leave unexercised. Options exercised before the modification keep their ISO treatment.

An extension can also bring section 409A into play for ISOs and NSOs alike. If the share value is above your exercise price when the window is extended, and the new deadline runs past the earlier of the option's original latest expiry date or 10 years from the original grant, the option is treated as deferred compensation from its original grant date, which can bring extra tax (26 CFR 1.409A-1(b)(5)(v)).

How much cash do you need to exercise and pay the tax?

You need the exercise price for every share, plus the tax the exercise creates, and shares of a private company may have no buyer to sell to.

Ask the company how it collects withholding from a former employee before the deadline, since there is no paycheck to take it from. Whether the stock is worth buying is your judgment; this page covers only the tax.

Can you exercise only part, or spread it across two tax years?

Yes, if your plan allows partial exercise, and each exercise is taxed in its own year. Tax on an NSO exercise falls in the year you exercise, and the ISO AMT adjustment belongs to the year of exercise (26 CFR 1.83-7; Instructions for Form 6251). A window that crosses December 31 lets you split the spread between two years, which can keep each year's ISO spread below the level where AMT starts or keep NSO wages out of a higher bracket. For ISOs, both parts still have to land within 3 months of your last day. For the December-or-January choice on ISOs, see AMT on incentive stock options.

If you let the options lapse, is there anything to deduct?

Usually not. A loss deduction cannot exceed your basis, and options you paid nothing for and reported no income on have no basis, so their lapse creates no deductible loss (26 CFR 1.165-1(c)(1); 26 CFR 1.83-7). No tax is owed on the lapse either.

Shares you already bought by exercising are different: you paid the exercise price and may have reported income or AMT on them. If those shares later fall or the company fails, see taxed on stock options that lost value and deducting shares in a failed startup.

Example

These examples are illustrative and use US dollars. Each person holds 30,000 vested options with a $1 exercise price, and the company's latest share value is $4.

ISOs exercised inside the window

Ana leaves on June 30 and exercises all 30,000 ISOs on August 15. She pays $30,000. No regular tax is due and nothing is withheld. Her Form 3921 shows the $1 price, the $4 value and 30,000 shares, a $90,000 spread ($120,000 value minus $30,000 paid), which she enters as an AMT adjustment on Form 6251, line 2i. Whether that brings AMT depends on the rest of her return.

The same ISOs exercised on day 120

Ben leaves on June 30 and exercises on October 28, more than 3 months later, within his plan's longer window. The options are taxed as NSOs. His former employer reports $90,000 of wages on his W-2, with code V. Assuming his total wages from that employer for the year, spread included, stay below the Social Security wage base, withholding at the flat rate is about $19,800 federal income tax, $5,580 Social Security and $1,305 Medicare. He needs about $56,700 in cash: $30,000 for the shares and $26,700 for withholding.

The window extended to five years

When Chen leaves, the company extends his window to five years, still inside the options' original 10-year term, while the share value is $4. The extension is a new grant at a $1 price on shares worth $4, so the options can no longer be ISOs from that date. In year three he exercises when the value is $10. The $270,000 spread ($300,000 minus $30,000) is wages on a W-2 from his former employer in the year of exercise.

Different for you?

• The exercise may bring AMT: size it with AMT on incentive stock options and get individual tax help before the deadline.
• You need the basics, forms or the sale rules: see exercising startup stock options.
• You already owe tax on shares that have since dropped: see taxed on stock options that lost value.
• The company failed after you exercised: see deducting shares in a failed startup.
• You want to know whether the exercised shares can qualify for QSBS: see QSBS for founders and early employees.
• You are leaving a job in Canada: see stock options for employees in Canada.
• The company offered to extend your window or change your options: have the new terms reviewed with individual tax help before you accept.