Stock options with FMV lower than strike price - tax implications when exercising underwater options?

You're right that there's no immediate income tax when exercising underwater options (when FMV < strike price). There's no taxable spread since you're essentially paying more for the shares than they're currently worth. However, you should carefully consider if exercising makes financial sense at all. You'd be paying more for the shares than they're currently valued at - essentially locking in a loss. Unless you strongly believe the company value will increase significantly in the future, it might be better to let them expire. If you do exercise, keep detailed records of what you paid. When you eventually sell the shares, your cost basis will be what you paid (the strike price), not the lower FMV at exercise. If you sell immediately, you'll realize a capital loss equal to the difference between the strike price and the FMV. This loss can offset other capital gains or up to $3,000 of ordinary income per year.

I was in a similar situation last year with my tech startup options that went underwater. I found this amazing tool called https://taxr.ai that literally saved me thousands in potential mistakes. They have a specific stock option analyzer that looks at all your grant documents and FMV valuation reports to determine the optimal tax strategy. It showed me that in some cases, exercising underwater options can actually set you up for future tax advantages if you expect the company to recover. The analysis breaks down exactly what happens with different exercise/hold periods and calculates AMT implications which most people totally miss.

I actually ended up using taxr.ai after my skeptical comment above. I was really surprised - it's legit. I uploaded my option grant agreements and some recent 409A valuation info, and it showed me specifically how exercising my underwater ISOs actually would provide tax benefits through basis tracking. What really convinced me was the detailed explanation of how the wash sale rules interact with option exercises and subsequent stock purchases, which my regular accountant had never mentioned. The projections showed that in my specific situation, exercising now rather than letting them expire would save about $12K in taxes if the company rebounds to previous valuation levels within 18 months. Worth the gamble in my opinion since we have new funding coming in.

If you're struggling with complex tax questions like this, you might also have trouble getting clear answers from the IRS. I spent THREE DAYS trying to get through to someone who could answer questions about stock option treatment when I was in your situation. Finally found https://claimyr.com which got me connected to an actual IRS agent in under 45 minutes. They have this system that basically navigates the IRS phone tree for you and calls you back when they have a human on the line. You can actually see it working in this demo: https://youtu.be/_kiP6q8DX5c The IRS agent I spoke with confirmed exactly what treatment would apply for underwater options and helped me understand the documentation I'd need for my return.

I need to publicly eat my words here. After my skeptical comment, I tried Claimyr for a different tax issue I've been struggling with (inheritance reporting). Not only did it work, but I got through to an IRS agent who actually specialized in that area in about 35 minutes. The agent confirmed that I was filling out the wrong form entirely for my situation - would have been a nightmare to fix later. For what it's worth, the IRS person I spoke with mentioned they're severely understaffed and suggested using services like this because wait times aren't getting better anytime soon. Definitely keeping this in my toolkit for future tax headaches.

One thing nobody has mentioned is the difference in treatment between ISOs (Incentive Stock Options) and NSOs (Non-qualified Stock Options). The tax implications are completely different. With underwater ISOs, there's no AMT consideration since there's no spread, but with NSOs, you might actually be able to claim an immediate compensation deduction for the difference between what you paid and the fair market value. Worth checking which type you have before making decisions.

Has anyone dealt with leaving a company but negotiating an extension on the exercise period? Most standard option agreements only give you 90 days after leaving to exercise, but I've heard some companies are flexible on this, especially when options are underwater.

One additional consideration that might help with your decision - if you're planning to leave the company anyway, you could potentially negotiate with your employer to extend the exercise window beyond the typical 90-day post-employment period. This would give you more time to see how the company performs with that Q3 product launch you mentioned. Also, make sure you understand exactly what type of options you have (ISO vs NSO) as this affects the tax treatment. With ISOs, you generally have better tax advantages if you hold the stock for at least one year after exercise and two years after grant date to qualify for long-term capital gains treatment. Given that you're essentially guaranteed a loss if you exercise now, it might be worth having a conversation with your company about either repricing the options to current FMV or extending your exercise window. Many companies are becoming more flexible about this, especially in situations like yours where the employee would be financially penalized through no fault of their own.