Understanding Early Exercise and 83(b) Elections

November 22, 2023

Stock options are a common form of employee compensation, providing employees with the opportunity to purchase shares of their company's stock at a predetermined price. While many employees are familiar with the concept of stock options, there's a lesser-known strategy that can be incredibly valuable: early exercising.

In this article, we'll be diving into the world of early exercising, exploring what it is, why employees might consider it, how it works for both non-qualified stock options and incentive stock options, and the pros and cons associated with doing so. We'll also discuss the reporting requirements of an 83(b) election and the consequences of not filing on time.

What is Early Exercising?

Early exercising is a strategy where an employee exercises their stock options before they fully vest. When employees exercise an option, underlying shares are purchased at a predetermined exercise price (strike price). Most companies don’t allow employees to exercise their options until the options have vested in accordance with their vesting schedule.

However, some private companies allow employees to exercise their options before they are vested. This means the employee will receive restricted stock that remains subject to the original vesting schedule, and while paying for something you still can’t sell might seem counterintuitive to some, it can be a powerful tool when used strategically.

Understanding NQSOs and ISOs

Before diving into the specifics of early exercise, let's briefly differentiate between NQSOs and ISOs, as the tax implications can vary depending on the type of award:

Nonqualified stock options: These are the most common type of stock options. When employees exercise vested NQSOs, they incur ordinary income tax on the difference between the fair market value of the shares and the exercise price.

Incentive stock options: ISOs offer potentially favorable tax treatment. There's no tax liability for regular tax purposes until the shares are sold but ISO exercises can be subject to the alternative minimum tax. Employees may qualify for long-term capital gains rates if they meet certain holding period requirements.

Why Consider Early Exercise

Freezing ordinary income tax (NQSOs): One primary reason an employee would consider early exercising is to freeze the tax paid on the spread between the exercise price and the fair market value of the shares. For NQSOs, this means locking in their ordinary income tax liability at the current value, potentially reducing future tax liability as the stock price increases.

Eliminating AMT (ISOs): For ISOs, early exercising can be even more advantageous. By early exercising ISOs, employees may reduce or eliminate their alternative minimum tax (AMT) liability. This can lead to significant tax savings for the employee and help them avoid being another AMT horror story. In addition, the exercise starts one of the holding periods that the employee must meet to qualify for long-term capital gains treatment on the sale.

QSBS holding period: For those at smaller companies considered to be qualified small businesses. Early exercising can also start the clock on the five-year holding period requirement. Here’s a great article from Carta for those looking to understand qualified small business stock in further depth.

How Early Exercise Works

As mentioned earlier, early exercising involves purchasing shares at their exercise price before they become vested. Here's how the process generally works:

Grant: Employees receive stock options as part of their compensation package.

Vesting: The options typically vest over a set period, with a common vesting period typically being over four years with a one-year cliff.

Exercise: Employees decide to early exercise some or all of their options. This means employees pay the exercise price to purchase the shares.

Ownership: Employees now own the shares, but they are subject to a buyback by the company if employees leave before they fully vest. This is a risk to consider.

Early Exercise Examples

Let's illustrate early exercise with two examples - one for NQSOs and one for ISOs:

NQSO Example: Imagine an employee has the opportunity to purchase 1,000 shares at a price of $10 per share. Currently, none of the shares have vested, and the current fair market value is $15 per share. The employee anticipates further appreciation in the stock's value and has decided to early exercise their NQSOs.

Tax Implications: By choosing to early exercise their options, the employee now owes ordinary income tax. This amount will be calculated based on the difference between the exercise price and the current fair market value at the time of exercise. Therefore, for the 1,000 shares exercised, this will translate to a taxable amount of $5,000.

1,000 shares x $5 spread per share = $5,000

This also ensures that for the employee, any further appreciation in the stock’s value will be subject to the more preferable long term capital gains rates (that is, if the required holding period for long term capital gains has been satisfied).

ISO Example: Like the previous example, imagine an employee has an agreement to buy 1,000 shares at $10 per share and the current fair market value is $15 per share. The employee elects to early exercise as they believe the stock’s value will continue to rise.

Tax Implications: Unlike the previous example with NQSOs, this exercise will not result in any immediate tax liability for regular tax purposes. Instead, the $5 spread will be subject to the alternative minimum tax calculation.

1,000 shares x $5 spread per share = $5,000

If the share price rises after the early exercise, this increase does not retroactively affect the AMT for the year of exercise. The AMT liability is calculated based on the spread at the time of exercise and is thus locked at the $5,000 amount.

For regular tax purposes, the employee won’t pay tax until the shares are sold. If the employee holds the stock for two years from the date of grant and one year from the date of exercise, the entire gain on the sale will be taxed as a capital gain. Exercising early can help employees meet this holding period. But if employees don’t meet the required holding periods, they’ll recognize ordinary income equity to the spread when the ISOs vest.

Reporting Requirements for 83(b) Elections

As in the above examples, if an employee does choose to early exercise their stock options, in order to reap the benefits of early exercising, the employee must file an 83(b) election with the IRS. This election informs the IRS that the employee wants to be taxed on the current value of the shares rather than waiting until they fully vest.

The 83(b) election must be filed within 30 days of an employee exercising their options and failing to file within that 30-day window means the employee will be subject to a tax obligation calculated upon the spread between grant date and vest date, rather than when the early exercise occurred, thus typically resulting in a higher tax obligation for the employee.

Cons of Early Exercising Stock Options

Risk of Forfeiture:

If the employee leaves the company before the shares are fully vested, there'’s a risk of losing the unvested shares. If employees forfeit their shares, they cannot claim a tax deduction or loss to recover the taxes paid on their early exercises.

Liquidity Concerns:

For employees in private companies, even after exercising options early and satisfying the service period of the award, limited liquidity in the private space means that employees cannot easily convert their shares into cash and may have to wait for a liquidity event like a company sale, IPO, or secondary market transaction.

The private space by nature is illiquid and has its own range of complexities and we encourage all equity professionals in the private space to take advantage of our seven-module private company course where industry experts guide you on the complexities of private companies, providing a foundation of knowledge that your start-up's equity programs can comfortably stand on.

Risk of Economic Loss:

And, of course, there’s no guarantee that the stock price will appreciate, even in a private company. If the stock declines in value after the exercise, employees could realize a loss on their investment. Even if the company has gone public and the stock is liquid, employees can’t sell to minimize their losses until they’ve met their vesting requirements.

Equity Compensation Fundamentals - Private Companies

Conclusion

Early exercising can be a powerful strategy for employees and the option to do so is most often seen as a plus in the eyes of potential talent, but it's not without its own risks and complexities. Whether employees have NQSOs or ISOs, understanding early exercising is an important facet for us as stock plan administrators and our role in providing clear guidance and understanding to our employees.

By Jason Mann
Content Director

NASPP