Early Exercising & 83(b) Elections
There are some words of wisdom from the world of Stock Based Compensation (SBC). Early exercise your options if you can, and if you do, make sure to file an 83(b) election with the IRS. There is much more to early exercising than that, and in this article, we'll dig deeper.
What is Early Exercising?
Certain companies allow their employees to exercise their options or restricted stock before it has vested. This is called early exercising. Here, early means any point in time prior to vesting. It could be the day you are granted options or a year before your options vest, as two examples. Mechanically, when you early exercise, you take ownership of your stock. Because your stock has not vested, you receive restricted stock, which converts into common stock upon satisfying vesting conditions.
The primary reason to early exercise is tax-related. You may want to qualify for long-term capital gains tax treatment, avoid AMT, and minimize the tax at exercise. All of these are tax reasons. The tax burden on your shares today may be much lower than when your company is potentially several times more valuable. Consider what the value of your shares may be between now and the end of your vesting schedule, which may be three, four, or five years away. The early exercise formula is simple:
Taxable Amount = Shares Elected * (Fair Market Value – Cost to Acquire Shares)
Here, the taxable amount is equal to the number of shares you elect to early exercise times the difference between the Fair Market Value (FMV) and the cost to acquire your shares. If you have options, the cost to acquire shares is your exercise price. If you have restricted stock, the cost to acquire shares is 0. In the end, the taxable amount will be taxed at the ordinary income tax rate. With early exercising, you can take advantage of your potentially low tax burden today, pay taxes on your shares today, and then potentially begin qualifying for long-term capital gains taxes. Per data from Carta in 2020, 15% of the options on its platform qualify for early exercise. Depending on your personal situation, you may or may not have this ability.
If you early exercise, then you must file an 83(b) election with the IRS within 30 days of exercising.
An 83(b) election is literally a form you mail into the IRS. It comes from Section 83(b) of the tax code and states that individuals can recognize their income on shares if they are unvested. The trick is that if you early exercise your options, the difference between your exercise price and the FMV of your stock is zero. Your shares have not appreciated at all. Therefore, you will pay to exercise your options (# of options times the exercise price), but you will pay no tax because there is no tax. This applies to options, not restricted stock (RSAs).
If you have RSAs and your employer allows for early exercising, you can early exercise and file an 83(b) as well. In this case, your exercise price is zero and the shares associated with your RSAs have an FMV in accordance with your 409A. The difference between zero and your FMV is the FMV, so you will pay ordinary income tax on the FMV of your shares.
You file an 83(b) when you receive shares by exercise early. It looks like this: when you early exercise your options or RSAs, you take receipt of shares, which allows you to file the 83(b). If you receive RSUs, you cannot early exercise because RSUs represent a unit award. When you file the 83(b) election, you are incurring the tax of receiving shares today. If you fail to file the 83(b) election, you will be subject to taxes on your vesting date based on the FMV of your shares when you vested, which is exactly the situation you are trying to avoid. Additionally, if you fail to file the 83(b) election properly, you will get no benefit on the capital gains side of the house.
When you file your 83(b) election, your holding period starts even though your shares have not vested. If you have NSOs or restricted stock, you have begun to qualify for long-term capital gains treatment. If you do not early exercise, two adverse situations may occur:
- You do not start the clock for long term capital gains treatment until you vest, exercise, and receive your shares.
- If you have Non-Qualified Stock Options (NSOs) or RSAs, when you vest and receive your shares, you will pay ordinary income tax on the FMV of your stock at that point in time, which may be much higher than if you had early exercised years before vesting. Now the potential spread that could one day qualify for capital gains tax treatment could be smaller.
There are a few nuances and common misconceptions that go along with early exercising:
- You can early exercise a portion of your SBC, so you can choose to early exercise 25% or 50% if you would like.
- The primary tax many look to avoid with early exercising is the Alternative Minimum Tax (AMT). If you hold ISOs, you could be subject to AMT, which taxes the paper gains on your options at exercise. You can think about AMT as a 26% – 28% tax on the difference between your exercise price and your FMV. When you early exercise, that difference is zero or close to zero, so many avoid AMT altogether with this strategy. You can read more on AMT here.
- You cannot start the clock early on qualifying for long-term capital gains tax treatment if you have ISOs. The primary motivation to early exercise ISOs is to minimize your tax burden by avoiding (or at the very least, minimizing) AMT. You can ask a tax professional to clarify. As we understand it, the reason is that the tax code for ISOs exclusively covers 83(b) elections in relation to AMT. The long-term capital gains clock only starts at the time of early exercise if you have NSOs or RSAs.
- Remember there is a $100,000 limit on the value of ISOs exercisable in any given year. Any ISOs exercise above the $100,000 limit are treated as NSOs and subject to certain taxes at exercise. The benefit of early exercising is that the FMV of your entire ISO grant could very well be below $100,000, so you avoid that limit.
- As this guide from JLevy references, if a company issues you SBC at a certain value, then raises a round at a higher valuation triggering an increase in the company’s 409A and associated FMV, and then if you choose to early exercise, you may be on the hook for a higher tax obligation than you would expect. This is why many advise folks who are going to early exercise to do so immediately upon receiving SBC.
- If you early exercise, file your 83(b), and then leave your company before vesting, your company has the right to repurchase your unvested, early exercised shares at their original issued price. You will also not be able to recover the taxes paid on those unvested shares.
- In addition, if you early exercise and file your 83(b) but your stock declines in price from the early exercise date, you will not be able to take a loss on the taxes you paid.
- Restricted stock units (RSUs) are not eligible for 83(b) elections. If you have RSUs, you may qualify for an 83(i) election, which has some tax advantages. Please consult a tax professional to discuss this further.
- Another potential risk with early exercising is your stock could decline in price following the early exercise date. This is less common with early stage companies and more common at mature private or public companies. There is a possibility that when you vest, your stock price is below the FMV when you early exercised, meaning you paid tax on income you never earned. If this does occur, you should be able to get a credit or refund on taxes paid.
- One of the most underrated benefits of early exercising is that you could be starting the clock to qualify for QSBS, or Qualified Small Business Stock, tax treatment. I write more about QSBS here, and if you are at a company early in its life, I would encourage you to ask a legal professional if you could qualify. With QSBS, you can realize millions of dollars in gains from tax.
If you wish to early exercise, do not go on the IRS’s website. They do not have a downloadable 83(b) form you can print, sign, and mail in. Instead, ask your company. If your company uses Carta, there is a downloadable form within the web portal. Otherwise, you can check out this instructional from Fidelity. Because of the strict 30-day period you have to file the 83(b), it is wise to request a return receipt upon mailing.