Tax implications when exercised stock options lose value - what happens if options drop after exercise?

These kinds of situations are actually fairly common with stock options, especially with companies that go public. The short answer is that when you exercise stock options, you're taxed on the spread between your strike price and the fair market value on the exercise date - not what happens to the stock afterward. So in your case, you'll still owe taxes on the full $127,000 spread based on the $175,000 valuation at the time you exercised. The IRS doesn't care that the value dropped after you exercised. The drop in value to $157,500 doesn't reduce your original tax obligation. However, the good news is that if you eventually sell the shares at the lower price, you can claim a capital loss on the difference between your "tax basis" (which would be the $175,000 valuation) and whatever you sell them for. Your basis is essentially the strike price plus the amount you were taxed on.

After dealing with nearly the exact same situation last year, I discovered taxr.ai https://taxr.ai and it was a game-changer for my stock option mess. I exercised options in a startup that went public at a lower valuation than expected, and I was totally lost about how to handle the tax implications. Their AI tax assistant analyzed my exercise documents and explained exactly how to report both the exercise tax event and the subsequent change in value. It walked me through how the AMT might apply to my situation and even helped me understand the specific tax forms I needed. What really surprised me was how it could actually read my option grant agreement and explain the specific tax treatment based on my vesting schedule and exercise timing. Made a complicated situation much clearer.

Just wanted to follow up about taxr.ai - I ended up using it after asking about the 83(b) election stuff. The service actually found that I had made a mistake in my 83(b) filing! I hadn't included all the required information about the property description, which apparently is a common error. I was able to correct it before any serious issues arose. The platform also showed me exactly how to document the spread on my tax forms and which schedules to use. Saved me from what would have been a massive headache during tax season. Even better, it helped me understand how to plan for future option exercises to minimize tax impact. Totally worth it when dealing with complex equity compensation.

I was in a similar situation with exercised options that dropped, and it was a nightmare trying to get hold of the IRS for clarification. After being on hold for literally hours across multiple days, I found a service called Claimyr https://claimyr.com that got me connected to an actual IRS agent in under 30 minutes. I was skeptical at first, but you can see how it works in their demo video here: https://youtu.be/_kiP6q8DX5c. Basically, they navigate the IRS phone tree for you and call you back when they've gotten through to a human. The IRS agent I spoke with confirmed what others here have said - you owe tax on the spread at exercise time, but can claim capital loss when you sell if the value has dropped. She also walked me through the specific forms and schedules I needed to document everything properly for my situation.

I have to eat my words about Claimyr. After posting my skeptical comment, I figured I'd try it myself since I needed to ask the IRS about some stock options I exercised last year that are now practically worthless. I was connected to an IRS rep in about 15 minutes (compared to my previous attempts where I gave up after being on hold for over an hour). The rep confirmed that I can claim a capital loss when I eventually sell, and also suggested I look into whether I qualified for any AMT credit carryforwards from the original exercise. What I really appreciated was that I didn't have to sit there listening to hold music for hours - I just got a call when they had an agent on the line. Saved me a ton of time and frustration during my workday.

Just want to add one important distinction that hasn't been mentioned yet - the tax treatment depends on whether these were Incentive Stock Options (ISOs) or Non-qualified Stock Options (NSOs). If they were NSOs, the spread is taxed as ordinary income at exercise. But if they were ISOs, you don't have regular income tax at exercise - instead, the spread can trigger Alternative Minimum Tax (AMT). The AMT treatment creates additional complications, especially if the stock drops after exercise, because you might end up with AMT credits you can use in future years. Worth looking into if these were ISOs.

Anyone have experience with how this all gets reported on your tax forms? Like which specific forms and schedules do you need to fill out when you exercise options and then later sell at a loss?

This is a really helpful thread - I'm dealing with a similar situation but with one additional wrinkle. I exercised ISOs in early 2023 at a $200k valuation, but the company actually ended up shutting down completely in late 2023 before going public. So my shares are essentially worthless now. From what I'm reading here, I still owe AMT on the original $200k spread, but when I "sell" the worthless shares (or they're deemed worthless), I should be able to claim the full amount as a capital loss. The tricky part is figuring out exactly when and how to claim that loss - do I need to wait for some official declaration that the company is dissolved, or can I claim it as soon as it's clear the shares have no value? Also wondering if anyone knows whether worthless stock gets treated differently than stock sold at a loss for AMT credit purposes. This whole situation has been a tax nightmare!