Filing an 83(b) election for beneficial tax purposes (as explained here ) requires (1) that you own securities and (2) that those securities are subject to restrictions that cause a substantial risk of forfeiture. When you receive stock options , you cannot immediately file an 83(b) because the first requirement is unsatisfied (i.e., you do not own the stock). However, some companies allow for “early exercising” of the options, which allows the option holder to exercise the options prior to vesting so that one owns the stock for an 83(b) election to be filed such that you may receive the potential tax benefits of an 83(b) election. This article will explain how early exercising works and will state some of the factors that should be considered when deciding whether to early exercise or not.
Understanding how stock options work is key to understanding how early exercising may benefit you. The life cycle of an option is: (1) a company grants the option to the holder, (2) the stock option vests according to a schedule, (3) the holder exercises the option, acquiring shares in the company at a “strike price,” and (4) the employee sells the shares.
Usually, the holder will exercise the options to buy shares after they vest. Over time, the price of the shares may increase, which is great for the holder because he is able to buy the shares at the lower strike price, but also subjects him to income tax on the difference between the present value of the shares when he exercises (the “exercise price”) and the strike price. Furthermore, when he sells his shares, he is still subject to more taxes. These additional taxes will be calculated from the difference between the strike price and the share sale price, and will be subject to income tax again unless certain conditions are met (for ISOs, if they are held for more than two years before sale from the grant date and more than one year from the exercise date, and for NQSOs, only if they are held more than one year from the exercise date), in which cases the taxes will be lower capital gains tax rates. Depending on whether the options were Non-Qualified Stock Options or Incentive Stock Options, the holder is taxed on the date the options were exercised or on the date when the shares are sold. In either case, one is taxed on the appreciation over the exercise price.
Alternatively, if early exercise is permitted, the holder can early exercise his options, which means that the holder owns the shares but such shares are still subject to the vesting schedule so it is possible to lose the shares if the holder does not meet the vesting conditions. The holder then files an 83(b) election to elect to pay taxes on the shares now prior to being vested. There is a risk that one pays taxes for shares that are later lost by not being vested, but there is a potential lowering of tax liabilities since the appreciate over the exercise price can be much less than if waiting until fully vested.
However, although early exercising can offer benefits, many factors must be weighed to determine whether it is the best course of action. First, early exercise requires that money be paid up front. If you wish to early exercise for all the shares, it may be more difficult for you to pay such a large sum up front.
Another consideration is that the shares may lose value over time. If you don’t exercise early, you can wait and decide not to exercise your option at all. If you exercise early, you may pay more for the shares than they ultimately end up being worth.
Furthermore, if you exercise early and file an 83(b) election, you have bought shares that haven’t vested yet. Most options have requirements that must be fulfilled (such as remaining an employee of the issuing entity) for the shares to vest. If you will not be able to meet all the criteria required for the vesting of all the shares, it may not make sense to pay taxes on the shares that would otherwise remain unvested.
This post lays out how “early exercise” of stock options works with respect to an 83(b) election, but please note that this post (1) is not provided in the course of and does not create or constitute an attorney-client relationship, (2) is not intended as solicitation, (3) is not intended to convey or constitute legal advice, and (4) is not a substitute for obtaining legal or tax advice from qualified professionals.