How do I report stock options I exercised at a startup?

The tax treatment depends entirely on whether you have Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs/NQSOs). Most startups grant ISOs to employees and NSOs to contractors/advisors.

Non-Qualified Stock Options (NSOs):

When you exercise NSOs, the difference between the exercise price and the fair market value (FMV) at exercise is treated as ordinary income and is reported on your W-2 (if you're an employee) or 1099-NEC (if you're a contractor). Your employer withholds income and payroll taxes on this "spread." Your cost basis in the shares becomes the FMV at exercise. When you later sell the shares, any additional gain or loss is a capital gain/loss reported on Form 8949 and Schedule D.

Incentive Stock Options (ISOs):

ISOs have more favorable treatment but are more complex:

• At exercise: No regular income tax is owed on the spread. However, the spread IS a preference item for the Alternative Minimum Tax (AMT) — reported on Form 6251.
• Qualifying disposition (held 2+ years from grant date AND 1+ year from exercise date): The entire gain from the exercise price to the sale price is taxed at long-term capital gains rates.
• Disqualifying disposition (sold before meeting both holding periods): The spread at exercise is reclassified as ordinary income, and any additional gain is capital gain.

Important startup-specific issues:

• 409A valuation: Your exercise price is based on a 409A valuation. If the startup hasn't gone public, determining FMV at exercise can be complex.
• 83(b) election: If you exercise early (before shares are fully vested), you can file an 83(b) election within 30 days to be taxed on the current (lower) value rather than the higher future value when shares vest. This election must be filed with the IRS — there are no extensions.
• AMT trap: Exercising ISOs at a startup with a high FMV but no liquidity can trigger a large AMT bill with no cash to pay it. Plan carefully.