I still don't understand why taxes are owed. If an option at the time of grant is worth $0 (which is how it's typically done or is that not the case?), then you don't owe anything to the IRS until you exercise the option, i.e. buy shares at the option price and sell them at presumably higher valuation and make some money, at which point you will need to part with some of it because it's income.
But if you never exercise the options, then you never owe any tax. What am I missing here?
If you exercise your ISO options (because of option expiration clauses, typically 90 days after you leave a company), but then don't (or can't due to no market for the shares) immediately sell those shares, the spread between the option grant price and the current 409A valuation is due as AMT tax. You have not realized an event where cash is in your pocket, but you still owe tax on the "gain".
You ask what does it matter if the options aren't exercised. Excellent question! It means all that potential compensation you were offered (because you took a lower salary usually in return for options) is now worthless. People don't want to work for free, or have their potential future compensation evaporate.
I see... So what should in theory fix it is if the company granting you the options also provided a guarantee that they will buy shares from you should you be inclined to sell them (A sort of a "sell at current price" option I suppose). This way you can exercise the options, and sell enough shares to cover the tax obligation and hang on to the rest.
Bookmarked to come back later to add detail. There is a better way where your company lets you exercise all your options immediately when you're hired, and you return non-vested shares when you leave.
Frequently, companies have a 90-day exercise window on options, meaning that employees have to exercise within 90 days of termination of employment. What that often translates into is employees sticking around indefinitely at companies whose value has grown during their tenure because they:
- can't exercise options and leave, because they would have to pay potentially huge taxes on an illiquid asset
- don't want to lose their stock, which makes up a nontrivial part of their comp for effort already invested in the company
So, your understanding is correct - but people often don't want to wait for a liquidity event to be able to exercise and don't want to miss out on something they already earned.
An example: as I hear it, there are quite a few early Uber employees sitting on tens or hundreds of millions of options who can't leave because if they exercise, they'd be slammed with millions in taxes. Since Travis Kalanick disallows secondary market trading of Uber stock, they wouldn't be able to sell stock to help pay the taxes, and thus can't afford to exercise but can't afford to leave. That's how you end up with employees who just come in to work the minimum possible amount waiting for an exit.
But if you never exercise the options, then you never owe any tax. What am I missing here?