In our constantly changing economic landscape, navigating the financial intricacies of an initial public offering (IPO) is a highly complex task. As interest rates shift, so do the strategies needed to maximize the benefits of your company's IPO. In this article, we’ll examine how declining interest rates create opportunities for employees and investors to optimize their IPO strategies.
The financial landscape of 2022 was marked by an unprecedented rise in interest rates. After the Fed interest rate spent nearly a decade and a half below the 3% mark—and most of that time below 1%—the Federal Reserve steadily raised rates from less than 0.1% to more than 5% in under a year and a half. This inflation-fighting strategy was the steepest increase since the sky-high interest rates of the early 1980s. This sharp rise sent shockwaves through the markets, precipitating dramatic declines in equities.
Both the Russell 2000 and Russell 1000 indices, key benchmarks for small and large-cap stocks, respectively, dropped by approximately 25%. Special purpose acquisition companies (SPACs), which had begun rising in popularity in 2020, were hit particularly hard. Even pre-IPO companies experienced severe devaluation during this time. For example, Stripe’s valuation fell by 50% and Instacart’s dropped 38%. For employees who were holding stock options, these valuation declines brought both challenges and opportunities, particularly in the context of tax planning.
The good news for employees is that declining valuations soften the tax impact of exercising stock options. Taxation is based on the difference between the strike price, or the price at which employees purchase stock in their companies, and the stock’s fair market value (FMV). In public companies, the FMV is the market price in the stock. In pre-IPO companies, FMV is determined by a 409A valuation. In both cases, the difference between the strike price and the FMV is called the bargain element.
There are two main types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs).
Only employees of the issuing companies are eligible to receive ISOs. While exercising this type of stock option has no impact on the regular income tax calculation, the bargain element is reportable for the alternative minimum tax (AMT) calculation. As such, it may or may not result in additional tax due. A tax planning professional who has experience working with pre-IPO employees can help you understand the potential tax impact of exercising ISOs at any given time.
It's important to understand that in order to get the full tax benefit of ISOs, the purchased shares must be held for more than one year after exercise and more than two years after the option grant date. Failure to meet these time requirements subjects the bargain element to regular income tax.
Companies may provide non-qualified stock options to employees as well as others such as vendors, consultants, and contractors. When employees exercise NSOs, the bargain element is reported on the W-2 as employment compensation and subject to regular income tax. This can present a significant challenge, as employees must pay income tax on unrealized gains in addition to the strike price. As with other types of investments, profits from the sale of exercised NSOs that have been held for more than a year are taxed at the long-term capital gains rate; if held for less than a year, the higher short-term rate applies.
Lower FMVs means a lower bargain element. As a result, the tax impact is softened when employees exercise shares when their companies’ FMV is lower. For example, imagine that your stock options have a strike price of $1. The stock’s FMV was $21 in 2021 and dropped to $11 in 2022. Shares exercised in 2021 would have a bargain element of $20 per share, while those exercised in 2022 would have a bargain element of just $10 per share.
If you exercised 100,000 ISOs in 2021, you would have a total bargain element of $2,000,000, which could result in a high AMT liability. In 2022, the same exercise would have a bargain element of $1,000,000, significantly reducing the impact of the AMT.
In the case of NSOs, the exercise of 100,000 shares in 2021 would add $2,000,000 to your W-2 income, while purchasing the same shares in 2022 would add $1,000,000. At a top income tax rate of 37%, exercising at the lower FMV would have saved you around $370,000.
While exercising incentive stock options during a downturn can provide tax advantages, it also poses some risk. AMT liability is "locked in" as of December 31 of the year the options are exercised. If the stock’s price drops further before that date, then the employee will owe taxes on paper gains that have since disappeared. If the drop is significant, they may be forced to sell shares in the down market to cover their tax liability.
For example, the market prices of both Uber and Facebook fell during the year of their IPOs. Employees who exercised options at IPO and held their shares past December 31 of that year had to calculate their AMT based on the exercise price, which was significantly higher than the December 31 value. As a result, some were forced to sell additional shares at a depressed price.
A knowledgeable tax and investment planning professional can advise you about the best timing for exercising your stock options based on your individual tax and financial picture and your company stock’s performance in the market.
Exercising stock options during periods of lower valuations provides advantages beyond simply lowering the current year’s tax bill. Employees may be able to take advantage of that savings to exercise even more options while incurring little or no additional tax obligation. In this way, they could bolster their future financial security with minimal impact on their present situation.
Pairing an NSO strategy with a move to lower tax jurisdiction can be attractive. If there is a fall in valuation, the tax cost of NSO exercise may decrease substantially. Since NSO exercise is considered part of compensation, even if you move after your stock vests, the state in which you earned the stock still claims the bargain element as wages in the state of origin.
If the value of the 409a is at parity or below the strike price, however, there shouldn’t be any tax liability included in the W-2 at exercise, eliminating the home state’s claim to the income. The subsequent gain on the exercised stock is portfolio income, which is only taxable in the state of residence.
As interest rates have fallen and markets have recovered, stock valuations have increased. Some industries, such as AI and biotech, could further benefit from increased public interest. With IPO activity still at historic lows, a resurgence is likely on the horizon. Venture capitalists, sitting on substantial cash reserves, are under pressure to generate returns, which could fuel a wave of new IPOs.
When planning your investment strategy, it’s important to be aware of anticipated changes to the tax laws. With the impending expiration of the Tax Cuts and Jobs Act (TCJA), 2026 is set to bring significant tax code changes that affect employees who are holding stock options.
For 2025, the AMT exemption is $88,100 for single filers and $137,000 for married joint filers. At the expiration of the TCJA, those exemptions are projected to drop to $70,900 for single filers and $110,400 for joint filers. In the event the TCJA is renewed, these exemptions would likely increase for 2026. The AMT exemption begins to phase out at a much higher income level under the TCJA, making it available to high earning taxpayers. Higher exemption rates and phaseout levels make exercising ISOs more cost effective.
The Pease limitation, eliminated by the TCJA, required taxpayers to reduce itemized deductions by 3% of their taxable income that fell above certain thresholds, capped at 80% of the total value of itemized deductions. The expiration of the TCJA would restore this provision, severely limiting itemized deductions for high income taxpayers.
TCJA doubled the estate tax exemption, which is at $13,990,000 for 2025. Expiration of the Act would essentially cut the exemption in half, dramatically increasing the potential tax consequences of passing stock on to heirs. Depending on the taxpayer’s income, amounts inherited above the exemption level could be taxed as much as 45% in 2026.
Falling interest rates and dips in valuation provide important opportunities for employees with stock options. By working with a trusted expert to understand the tax implications of exercise and engage in strategic planning, you can limit your tax burden and maximize after-tax gains. At WRP Wealth Management, we specialize in helping employees make the most of their companies' IPOs. We’ll guide you through every step of the process, providing clarity so you can invest with confidence. For more insights into the IPO process, stock options, and tax planning, check out our resource library.