What Is an IPO? The Process, the Lockup, and the Tax Bill

Nothing automatic, which surprises almost everyone. The real question behind “what is an IPO” for most employees is what happens to their equity, and the short answer is: on listing day, nothing does. An initial public offering is a corporate financing event, not a taxable event for option holders. Your vested options stay vested. Your unvested options keep vesting on the same schedule. Your strike price does not change, your grant date does not change, and no money moves. What changes is that a real, observable market price now exists for the underlying stock, and that price replaces the 409A appraisal your company had been using. Everything that follows, the size of your spread, your alternative minimum tax exposure, your withholding shortfall, is measured against that public price. So the IPO doesn’t tax you. It just turns a hypothetical number into a number the IRS can verify.

What kind of option you hold decides everything after that. Incentive stock options are governed by IRC section 422, and they’re the more favorable instrument if you can afford to hold. Exercising an ISO produces zero regular taxable income. If you then hold the shares more than two years from the grant date and more than one year from the exercise date, the entire difference between your strike price and your eventual sale price is long-term capital gain, taxed at 0%, 15%, or 20% depending on your income rather than at ordinary rates that top out at 37%. Break either holding period and you have a disqualifying disposition: the spread measured at exercise converts to ordinary compensation income and only the appreciation after that stays capital. Your employer is required to report each ISO exercise to you and to the IRS on Form 3921, so the Service knows the exercise happened even in a year you report nothing.

Nonqualified stock options work the way ordinary compensation works. Under IRC section 83(a), the moment you exercise an NSO, the spread between your strike price and the fair market value that day is wage income. It lands in Box 1 of your Form W-2, it’s subject to Social Security and Medicare tax, and your employer withholds federal and state income tax on it. Your basis in the shares becomes the full fair market value at exercise, and any movement after that is capital gain or loss reported on Form 8949 and Schedule D. The IRS summarizes both regimes in Tax Topic 427.

Now the timing problem, because this is where an IPO does real damage. Your options may become exercisable the day the company lists, but your shares are almost certainly locked up for 180 days. Exercising an NSO during that window means paying the strike price in cash, generating a large wage event on your W-2, and owning shares you legally cannot sell to fund the resulting tax. If the stock falls between exercise and lockup expiration, the tax is still computed on the higher exercise-date value. There is no adjustment for the price you eventually get.

Here’s what that looks like with real numbers. Say you hold 40,000 nonqualified options with a $2.00 strike, your company prices its IPO at $30, and the stock is trading at $34 when you exercise. Your ordinary income is 40,000 times $32, or $1,280,000, on top of a $220,000 salary. Your employer withholds at the supplemental rates described in Publication 15: 22% on the first $1,000,000 of supplemental wages, which is $220,000, and a mandatory 37% on the remaining $280,000, which is $103,600. Total federal withholding of $323,600, an effective 25.3% on money that will actually be taxed at 35% and 37% at the margin. The real federal tax on that block runs somewhere around $448,000. You’re short roughly $124,000 before New York State, whose top bracket reaches 10.9%, and New York City, which adds a resident income tax on top of that, get involved. Nobody sends you an invoice. You find out in April.

The ISO version of the same story is quieter and often worse, because the bill arrives with no withholding at all. Exercise 20,000 ISOs with a $1.50 strike when the shares are worth $18, and you have a $330,000 alternative minimum tax adjustment on Form 6251, no regular income, and a tentative AMT liability that can easily run $70,000 to $90,000 in cash, due next April, with no employer withholding a dime and no ability to sell the shares. The AMT you pay generates a minimum tax credit under IRC section 53 that you recover in later years on Form 8801, but a credit you claim over five years does not pay a tax bill due in five months.

The common mistake: assuming an exercise-and-hold is the tax-efficient move because someone on a message board said long-term capital gains are better. They are, but only if you survive the holding period with your finances intact and the stock doesn’t collapse. The other frequent error is the Form 1099-B basis problem. Brokers routinely report only your strike price as cost basis on a cashless NSO exercise, which means the spread you already paid ordinary income tax on gets taxed a second time as capital gain unless you adjust the basis on Form 8949. We catch this on new client returns constantly, and it is worth tens of thousands of dollars. Also watch the $100,000 rule in section 422(d): the aggregate fair market value, measured at grant, of stock for which your ISOs first become exercisable in any calendar year cannot exceed $100,000. Anything above that is treated as a nonqualified option, so the grant you think is entirely ISO may not be.

Looking forward, the decision worth making before your company files its S-1 is not whether to exercise but how much you can afford to exercise and still sleep. Run the numbers on a partial exercise, model the AMT at several assumed valuations, and decide in advance what price you’d sell at the moment the lockup lifts. Our capital gains tax strategies guide covers the holding-period math that decides whether waiting is worth the risk. This is general information rather than advice about your situation, talk to a licensed CPA before you exercise anything, because the sequence and the size are far more important than the decision to exercise at all.

Understanding what is an IPO lockup starts with who imposes it. The lockup is the most misunderstood piece of the entire IPO process, mostly because people assume the government imposes it. It doesn’t. A lockup agreement is a private contract between the company’s insiders, officers, directors, employees, and pre-IPO investors, and the underwriting banks running the offering. The banks require it because they’ve just sold a large block of stock to institutional buyers at a negotiated price, and a wave of insider selling in week two would destroy that price and their relationship with those buyers. So the standard term is 180 days from the offering date, and during that window you cannot sell, gift, pledge, hedge, or otherwise transfer your shares.

Because it’s a contract rather than a rule, the terms vary far more than people expect. Some companies negotiate 90-day lockups. Many now use staggered releases, where a percentage of shares frees up after the first earnings release and the rest at 180 days. Early-release provisions tied to price performance have become common, if the stock trades above a set percentage of the IPO price for a defined number of days after the first earnings report, a tranche unlocks early. Your specific terms are in the lockup agreement you signed and in the underwriting section of the prospectus, which you can pull from EDGAR for free. Read your own document. Do not rely on the number a coworker repeats in Slack.

Separate from the contractual lockup, federal securities law imposes its own restrictions that outlast it. Rule 144 governs resale of restricted securities and control securities. Shares you acquired in a private transaction before the IPO are restricted securities and generally require a six-month holding period for a reporting company. If you’re an affiliate, an officer, director, or large shareholder. You also face volume limits capping sales in any three-month period at the greater of 1% of outstanding shares or the average weekly trading volume over the preceding four weeks, plus a Form 144 notice filing. Non-affiliate employees who hold shares from option exercises after registration usually clear these hurdles easily, but people who bought founder stock in a private round often do not. The registration forms and rules are indexed on the SEC’s forms page.

Layered on top of both is your company’s own insider trading policy, which typically closes a trading window from roughly two weeks before quarter end until two business days after earnings are released. If you’re on a designated insider list, you may also need preclearance from the general counsel for every trade. Add it up and a mid-level employee at a company that IPOs in March may find the first genuinely open selling window falls in mid-September, six months and one earnings cycle later.

Can you get out early? Rarely, and the workarounds are worse than they look. Underwriters can waive a lockup, and occasionally do for hardship, but a waiver for one employee sets a precedent nobody wants to set. Prepaid variable forward contracts and collars are almost always prohibited outright by the lockup agreement’s anti-hedging language. The one legitimate tool is a Rule 10b5-1 trading plan, which lets you set up automatic sales in advance while you don’t possess material nonpublic information; the SEC amended the rule to add mandatory cooling-off periods, so a plan adopted today doesn’t start trading immediately. A 10b5-1 plan doesn’t override the lockup, but it does let you queue up disciplined selling for the moment the lockup lifts, which is genuinely useful.

Here’s the arithmetic that makes this urgent. Suppose your double-trigger RSUs settle at the IPO price of $28 and you receive 30,000 shares, producing $840,000 of ordinary wage income under IRC section 83. Your employer withholds shares to cover 22% federal, per Publication 15, leaving you roughly 20,000 net shares and a federal shortfall of about $110,000 because your real marginal rate is 37%. Six months later the lockup lifts and the stock is at $15. Your remaining shares are worth $300,000. You still owe tax computed on $840,000, and you now have a capital loss of about $260,000 that you can only use $3,000 of per year against ordinary income under the capital loss limitation. The tax and the loss live in different buckets and they don’t cancel out. That mismatch has bankrupted people, and it happened at scale after the 2000 and 2021 IPO cohorts.

The common mistake: treating the lockup expiration date as a market event to trade around rather than a personal deadline to plan for. Employees routinely wait past the unlock hoping for a better price, blow through the fourth-quarter estimated tax deadline, and pay underpayment interest on top of an already ugly bill. The second mistake is forgetting that the lockup does nothing to defer the tax. Your income was fixed on the settlement or exercise date. The lockup only restricts your ability to fund it. If your tax event and your liquidity date are more than a few weeks apart, you are carrying market risk on money you already owe the government.

Two smaller details decide more outcomes than people expect. First, a lockup restricts transfer, not vesting, so RSUs keep settling and options keep vesting on schedule during the entire window. Second, the price you see quoted in the first week of trading is usually not the price available to you six months later; the historical pattern across IPO cohorts is that a meaningful share of newly listed stocks trade below their offering price by the time the standard lockup expires. Planning that assumes the debut price will hold is planning on the least reliable number in the whole transaction.

Going forward, the useful move is to write down three numbers before your company lists: the dollar amount of tax you’ll owe on the equity event, the number of shares you’d need to sell at various prices to cover it, and the price below which you sell regardless of how you feel about the company. Put a 10b5-1 plan in place if your policy allows it, and make the first estimated payment on Form 1040-ES in the quarter the income actually hits rather than waiting for April. Our tax strategy guides cover the estimated payment mechanics. As always, this is general information and not advice about your circumstances; a licensed CPA should look at your actual grant documents before you commit to a plan.

Because withholding on supplemental wages is a flat statutory rate, and your actual tax is not. If you came here asking what is an IPO going to cost me, this is the line item. That’s the whole answer, but the gap it creates is large enough that it deserves the long version, because it catches sophisticated people every single IPO cycle.

Start with what an RSU is. A restricted stock unit is a promise to deliver shares later. It isn’t stock, you don’t own it, and you can’t make an 83(b) election on it because there’s no property transferred yet. At a private company, RSUs almost always carry two vesting conditions. A service condition that runs on a four-year schedule with a one-year cliff, and a liquidity condition satisfied only by an IPO, a direct listing, or an acquisition. That double-trigger design exists for your benefit. Without it, you’d owe ordinary income tax on illiquid shares you couldn’t sell to pay it, which is exactly the disaster the structure prevents.

Then the company goes public and the liquidity condition is met. Every RSU that has already satisfied its service condition settles simultaneously. An employee four years in can see the entire grant land in one pay period. Under IRC section 83, the fair market value of the delivered shares is ordinary compensation income, the full value, not a gain, because you paid nothing for them. It goes in Box 1 of your Form W-2 and it’s wages for Social Security and Medicare purposes too.

Here’s where the shortfall is manufactured. IRS Publication 15 sets the optional flat rate for supplemental wages at 22%, and requires a mandatory 37% rate on supplemental wages above $1,000,000 in a calendar year. Virtually every equity administration platform defaults to 22%, because that’s the rule and because payroll systems are built for the median employee, not for someone whose income just multiplied by six. The company isn’t doing anything wrong. It’s following the regulation. The regulation just wasn’t designed for a person whose marginal rate is 35% or 37%.

Work an example. You have 45,000 RSUs fully time-vested, the IPO prices at $22, and settlement occurs at that price. Your compensation income is $990,000, added to a $210,000 base salary for total wages of $1,200,000. The equity platform withholds 22% of $990,000, or $217,800, usually by selling or netting shares. Your true federal tax on that $990,000 block, sitting on top of a $210,000 salary and taxed almost entirely in the 35% and 37% brackets, is roughly $350,000. You are approximately $132,000 short on federal alone. Then add New York: the state’s top bracket runs to 10.9% and New York City layers a resident income tax on top of it, and neither is covered by that 22%. Add the 0.9% Additional Medicare Tax that applies to wages over $200,000 for a single filer or $250,000 for joint filers, which many payroll systems compute correctly but which still increases the total. The all-in gap for a New York City resident in this example comfortably exceeds $200,000.

There’s also the loss of the state and local tax deduction to consider. The SALT cap limits what you can deduct on Schedule A regardless of how much New York tax you pay, so your New York liability doesn’t shelter your federal one the way it would have decades ago. And if your RSU income pushes your modified adjusted gross income high enough, the 3.8% net investment income tax under IRC section 1411 starts hitting your unrelated interest, dividends, and capital gains, because the threshold is $200,000 single and $250,000 joint and it has never been indexed for inflation.

The common mistake: assuming the company handled it. Employees see shares withheld for taxes on their equity portal, read the words “taxes withheld,” and conclude the obligation is settled. It is not. The second mistake is failing to make an estimated payment. Federal law expects you to pay tax as you earn income, and a huge Q1 or Q2 equity event with inadequate withholding triggers an underpayment penalty computed quarterly on Form 2210, even if you pay everything by April 15. The safe harbor is generally paying 100% of your prior year tax, or 110% if your prior year adjusted gross income exceeded $150,000, or 90% of the current year, and in an IPO year, prior-year safe harbor is usually the cheapest route because your prior year was normal.

Some companies allow you to elect a higher withholding rate on supplemental wages, and some do not; the flat-rate method under the regulations doesn’t let an employer withhold at a higher flat percentage than the statutory rate, so the practical fix is usually to submit a revised Form W-4 requesting additional withholding from regular paychecks, or to write an estimated tax check on Form 1040-ES for the quarter in which the shares settled. Either works. Doing nothing does not.

Share withholding itself deserves a second look. Most companies satisfy the withholding by netting shares. They keep enough of your settled shares to cover the 22% and deliver the rest. That is efficient, but it also means the company decided how many shares you sold and at what moment, and it means your remaining position is larger and more concentrated than you may realize. If your entire net worth is now a single ticker you cannot sell for six months, the tax shortfall is only half the problem you have.

One more wrinkle worth knowing if you’ve moved: New York allocates equity compensation earned while working in the state to New York even after you leave, generally over the period from grant to vest. Move to Florida in year three of a four-year grant and New York will still claim a share of the income based on your workdays in-state during the vesting period. People move for the IPO and are shocked to get a New York assessment eighteen months later.

Looking ahead, treat the settlement date as the day your tax was fixed and every day after as market risk you’re taking with the government’s money. Sell enough shares at unlock to fully cover the gap, make the estimated payment in the correct quarter, and check your withholding against the safe harbor before year end rather than in April. Our guide to how Form 1040 works shows where wage income and withholding actually reconcile on the return. This is general information rather than tax or legal advice; get a licensed CPA to run your specific numbers before the fourth-quarter estimated deadline passes.

Quite possibly. For early employees this is the sharpest edge of what is an IPO, and it’s the reason more pre-IPO employees have gotten into financial trouble than any other single provision in the tax code. The alternative minimum tax is a parallel tax system with its own income definition, its own exemption, and its own rates of 26% and 28%. You compute your regular tax, you compute your tentative minimum tax on Form 6251, and you pay whichever is higher. For most people the regular tax wins and Form 6251 never matters. Exercise a meaningful block of incentive stock options and that flips.

The mechanism is specific. When you exercise an ISO, IRC section 422 keeps the spread out of your regular taxable income. But IRC section 56(b)(3) says that for AMT purposes, section 422 simply doesn’t apply, so the bargain element, meaning fair market value at exercise minus what you paid, becomes an AMT adjustment in the year of exercise. At a private company, “fair market value” is the current 409A appraisal. The stock is not tradeable, you may not be able to sell a single share, and you owe cash anyway. The IRS explains the mechanics in Tax Topic 427, and your employer’s Form 3921 gives the Service the exercise date, the strike price, and the valuation.

The exemption is what determines whether the adjustment actually costs you. Every taxpayer gets an AMT exemption that reduces alternative minimum taxable income, and that exemption phases out at higher income levels. Both the exemption and the phaseout thresholds are reset each year by an IRS revenue procedure, so use the figure for your actual filing year rather than one you read somewhere. What matters directionally is that the One Big Beautiful Bill Act reset the phaseout thresholds sharply lower beginning in 2026 and doubled the phaseout rate, so the same ISO exercise that produced no AMT under the prior rules can produce a real bill now. If you were relying on planning from 2022, redo it.

Here is the arithmetic with real numbers. You hold 25,000 ISOs at a $1.20 strike. The current 409A valuation is $16.00. You exercise all of them: cash out of pocket is $30,000 for the strike, and your AMT adjustment is 25,000 times $14.80, or $370,000. Assume you’re married filing jointly with $250,000 of other income. Your regular tax on that $250,000 might be roughly $44,000. Your alternative minimum taxable income becomes about $620,000, which is above the phaseout range, so the exemption is largely or entirely gone, and 28% applied to most of that base produces a tentative minimum tax in the neighborhood of $165,000. You pay the higher number. The AMT you owe above your regular tax is roughly $120,000, due the following April, on shares you cannot sell, with zero withholding. The $30,000 exercise cost was never the expensive part.

The money isn’t gone forever. AMT paid because of a deferral item like an ISO exercise generates a minimum tax credit under IRC section 53, claimed in later years on Form 8801 to the extent your regular tax exceeds your tentative minimum tax in those years. In practice, recovering a $120,000 credit takes years, and it only comes back at a few thousand dollars a year for someone with a stable salary. Also remember your AMT basis in the shares is higher than your regular basis by the amount of the adjustment, which reduces AMT gain when you eventually sell, a second recovery channel most people never claim because their preparer didn’t track dual basis.

One planning tool people overlook entirely is the same-year disqualifying disposition. If you exercise an ISO in March and sell the shares in November of the same calendar year, the AMT adjustment disappears, because the shares are no longer held at year end. You lose the favorable capital gain treatment and pick up ordinary income on the spread instead, but you also eliminate the cash-without-liquidity problem completely. For a private company employee that escape hatch usually is not available, since there’s no market to sell into. For someone exercising after the IPO but during an open trading window, it is a genuine option and it is almost never discussed.

The common mistake: exercising the entire grant in December because someone said to start the holding period. The smarter versions of this play are exercising early in the calendar year, so that if the valuation collapses you still have time for a same-year disqualifying disposition that eliminates the AMT adjustment entirely, and exercising in tranches sized to stay under the level at which AMT starts to bite. The other frequent error is forgetting the section 422(d) $100,000 limit, the aggregate fair market value at grant of stock for which your ISOs first become exercisable in any calendar year cannot exceed $100,000, and the excess is automatically treated as nonqualified. Employees who assume their whole grant is ISO sometimes find half of it produces immediate W-2 income instead.

There’s a hard truth in here that a good advisor will say out loud. If your company never goes public, or lists at a fraction of the last private round, you will have paid six figures of cash tax on paper value that evaporated. The credit recovers slowly and only against future regular tax. Exercising a large ISO block at a private company is a bet placed with borrowed conviction, and it should be sized like one. A number you can lose without changing how you live.

Going forward, the discipline is simple even if the math isn’t. Before exercising, model the AMT at the current 409A value, model it at half that value, and decide how many shares you can exercise while keeping the incremental AMT to an amount you’d accept losing. Make an estimated payment on Form 1040-ES in the quarter you exercise, not next April. Keep your Form 3921s permanently, because you’ll need them to compute dual basis on the eventual sale. Our tax strategy guides cover the planning sequence. This is general information and not tax or legal advice for your situation; run your own numbers with a licensed CPA before you exercise a single option.

Yes, and this is the most valuable thing in this entire guide. The qualified small business stock rules in IRC section 1202 let a noncorporate shareholder exclude a large chunk of gain, potentially all of it, on the sale of stock in a company that was small when the stock was issued. The size test looks at the company’s gross assets at the time of issuance and immediately after. It does not look at what the company is worth when you sell. That means a company can go public at an enormous valuation and the founder stock or early exercised options issued when it had two employees and a rented desk are still qualified small business stock.

The requirements are strict and each one is a genuine tripwire. The issuer has to be a domestic C corporation, both when the stock is issued and substantially throughout your holding period, which is why a company that started as an LLC and converted has a QSBS clock that begins at conversion, not at formation. You have to acquire the stock at original issuance, directly from the company, in exchange for money, property, or services. Buying shares from another shareholder on a secondary market does not qualify, which trips up employees who bought from a departing colleague. The corporation must use at least 80% of its assets in the active conduct of a qualified trade or business. And section 1202(e)(3) excludes a long list of fields outright: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage, banking, insurance, farming, and any business where the principal asset is the reputation or skill of its employees. Software and product companies generally qualify. A consulting firm does not, and no accounting firm’s stock has ever been QSBS.

The 2025 changes matter enormously depending on when your shares were issued. For stock issued after July 4, 2025, the One Big Beautiful Bill Act introduced a tiered exclusion: 50% of eligible gain after a three-year holding period, 75% after four years, and 100% after five. It raised the per-issuer gain cap from $10 million to $15 million, with inflation indexing, and lifted the aggregate gross assets ceiling from $50 million to $75 million. Stock issued on or before July 4, 2025 stays under the prior regime, a flat five-year holding period for the 100% exclusion, a $10 million per-issuer cap, and a $50 million asset test. Both regimes keep the alternative cap of ten times your aggregate adjusted basis in the stock, which is the provision that lets founders with near-zero basis exclude far more than the flat dollar cap when the basis is large. Confirm which set of rules governs your specific certificate before planning around either.

Now the worked example, because the numbers are startling. You joined a software company in 2019 as employee number six and early-exercised 300,000 options at $0.04, paying $12,000 and filing an 83(b) election within 30 days. The company was worth $6 million in gross assets at the time, comfortably under the old $50 million ceiling. Six years later it IPOs, and after the lockup you sell the entire position at $52 a share for $15,600,000. Your gain is $15,588,000. Because the stock was issued before July 4, 2025, your per-issuer cap is the greater of $10 million or ten times your $12,000 basis, which is $120,000, so the $10 million flat cap controls. You exclude $10,000,000 of gain from federal income tax entirely, and that excluded gain is also outside the 3.8% net investment income tax under IRC section 1411. The remaining $5,588,000 is ordinary long-term capital gain, taxed at 20% plus the 3.8% surtax. The exclusion saved roughly $2.38 million in federal tax. That is not a rounding error, and it happened because someone exercised early, filed an 83(b), and kept the paperwork.

State treatment is its own question and people assume wrongly here. New York generally conforms to the federal exclusion because it starts from federal adjusted gross income, but several states, California most prominently, do not allow the section 1202 exclusion at all, so a California resident with the same facts owes full state tax on the entire gain. Check the state where you’ll be a resident in the year of sale, not the state where you earned the stock, and read the guidance published by that state’s revenue department rather than a summary. New York’s individual income tax materials are at the New York State Department of Taxation and Finance.

The common mistake: selling at the five-year mark minus three weeks. The holding period is measured to the day, and there is no rounding and no equitable exception. If you’re close, IRC section 1045 allows a rollover of QSBS gain into replacement QSBS within 60 days if you’ve held more than six months, which can preserve the character when a sale is forced by an acquisition. The second common mistake is never obtaining written confirmation from the company that the stock qualified, gross asset values at the time of issuance, the C corporation status, the active business test. Companies are usually willing to provide a QSBS attestation while the people who remember the early balance sheet still work there. Ten years later, after two CFOs and an acquisition, nobody can reconstruct it, and the exclusion becomes very hard to defend on audit. Get the letter now. It costs nothing.

Reporting matters too. QSBS gain is reported on Form 8949 with the exclusion entered as a negative adjustment using the appropriate code, and it flows to Schedule D. Your broker’s Form 1099-B will report the full proceeds with no indication that any of it is excludable, because the broker has no way to know. If your preparer just imports the 1099-B and moves on, you will pay tax on gain you were entitled to exclude, and amended-return recovery is possible but tedious.

Looking forward, the QSBS analysis should happen before the IPO, not after the sale. Confirm the C corporation history and conversion date, confirm original issuance, gather the 83(b) filing and the exercise records, get the company attestation, and calendar the five-year date. Our capital gains tax strategies guide covers how the exclusion interacts with the rest of a concentrated position. This page is general information, not tax or legal advice; section 1202 is unforgiving about details, so have a licensed CPA verify your facts against the statute before you rely on any of it.