Question from Quora:
If my option grant consists of both ISO & NSO stocks at the same exercise price, should I exercise the ISO grant in priority or the NSO grant?
I expect the market price of the stocks to go much higher than their exercise price. I don't have enough money to exercise all my options but I'd be with the company till it goes public. You can also assume that IPO event would be a few years after this exericse.
That means, with my limited money, I can either exercise some of my ISO options or exercise some of my NSO options. Which ones should I exericse? ISO grant has already already started vesting whereas NSO grant would start vesting in about a year.
My understanding is I should first exercise NSO first so that I can reduce my total compensation tax. Is that correct?
Dan Walter's Answer
Part of this will depend on the current spread between your grant/exercise price and the current value of the company stock. The spread will determine the amount of immediate ordinary income on the NQSOs, if they are vested at the time of exercise. If the spread is large, the associated taxes may be too much to bear and it may make more sense to exercise your ISOs and hold them.
If the options are not yet vested, and you are allowed to exercise prior to vest, then the current spread is still important, but the ability to set your ordinary income now may be the deciding factor. If you exercise unvested NQSOs you can generally file an "83(b) Election" with the IRS. This election allows you to choose to have ordinary income calculated at the time of exercise and you would then be responsible for remitting appropriate taxes.This can greatly reduce your tax burden when you actually sell the shares. (search "83(b)" on Page on quora.com for more information).
If the spread is enough to make the current tax burden on NQSO onerous, then exercising your ISOs may make more sense. Exercising your ISOs and holding the resulting shares starts your capital gain holding period (2 years from the date of grant and 1 year from the date of exercise.) If you sell or otherwise transfer your shares after this dual holding period is met your gain will be subject to (currently) much lower capital gains rates, rather then ordinary income rates.
So, in conclusion: If you have the money and can bear the risk of an IPO never happening (you may then be stuck with trying to right down your taxes paid against future losses), then you would probably want to exercise your NQSOs. If you have less money, and don;t want to take the risk of taxes paid, then ISOs are likely the right choice.
DISCLAIMER AND NOTE: I am not a tax adviser and nothing in this post should be considered tax advice. Before you do an equity transaction speak directly with someone who is both qualified and licenses to provide tax advice. Your specific circumstances may alter many aspects of this answer and recommendations may need to changed accordingly.