I thought I understood this but the lockup that everyone in this discussion is alluding to has surprised me. Should the tax man not count the price of the security on the day the lockup ends as the strike price? Otherwise, any time you get discounted options with a lockup, it appears you should assume the options will go to zero and budget the tax accordingly. Or am I missing something?
The tax code counts the price at the time of exercise, not at the time the lockup ends. (A lockup is a contractual obligation not to sell the shares: you still own them, you just can't sell them.) The logic, I guess, is that there are other types of property (eg. real estate, private company shares, collectibles) that you may not be able to sell on a liquid market, but they are still items of value that you've received, and you should still be taxed on them at the time of receipt.
You could argue about the morality and rationality of this decision: some people would say it's both wrong and somewhat unfeasible to levy taxes that people have no way of paying. But that's the law for now. There are other scenarios that can get people into this situation as well: cryptocurrency transactions, property taxes, wealth taxes in general. Indeed, one reason we have Prop 13 in California is because seniors were being forced out of their homes because they couldn't pay the taxes, but that brought with it a whole bunch of other undesirable economic distortions.
From the employee POV, your best options are usually to either a.) file an 83(b) election as soon as you receive the stock options, indicating that you'd like to be taxed on their current fair market value (which is usually zero at the time you receive them, because most strike prices are set at the current market price) and have all future gains taxed as capital gains with a cost basis set at the time of the 83(b) election, or b.) don't exercise your shares until you're ready to sell them.
