From time to time, and primarily when the economy is booming, allowing stock options to be “early exercised”—that is, allowing options to be exercised before they are vested—becomes in vogue. We are in one of those times. Ordinarily, the capital gains holding period for the stock underlying an option begins when the vested option is exercised: The primary objective of exercising an unvested option is to start that capital gains holding period before the option would otherwise vest. Though that sounds great in theory, depending on the type of option being exercised and the time at which it is exercised, early exercising an option may not necessarily achieve the intended tax benefits. We describe some of the traps for the unwary and some related practical considerations in the post.
To set the stage, it helps to understand how regular stock options are used and how they are taxed. Stock options give employees the right to buy shares of the company’s stock at a price, known as the exercise or strike price, that is equal to the fair market value of the stock at the time the option is granted. Over time—the hope is—the value of the company’s stock will grow (in part by dint of the option holder’s own efforts) so that when the option holder exercises the option, the option holder can buy company stock for less than its fair market value at exercise. The option holder—now stockholder—can then sell the stock (subject to any restrictions on transfer the company may impose) and keep the profits or continue to hold the stock and participate in any future growth as an investor in the company.
To ensure that the option holder actually participates in company value creation, the right to exercise a stock option usually vests over time. Commonly, for example, an option holder earns the right to exercise the option with respect to 25% of the shares underlying the option after one complete year of service and in equal monthly or quarterly installments for three years after that. Once the option is vested, the option holder can choose when (and the extent to which) to exercise the option. If the option holder leaves the company before the award is fully vested, the unvested portion of the award is forfeited. And any vested portion of an award must be exercised by the option holder shortly after any termination of services or it too will be forfeited.
As we’ve described elsewhere, the tax consequences of this form of compensation depend on the type of option that has been granted.
- If the option is an incentive stock option (ISO), there is no tax at grant, as the option vests, or at exercise. If the option holder holds the stock received upon exercise until a date that is more than two years from the date of grant and one year from the date of exercise, the difference between the sale price and the exercise price will be long-term capital gain (or loss). If either of those holding periods is not met, then at the time the stock is sold the option holder will have compensation income equal to the difference between the fair market value of the stock at exercise and the exercise price—or the option holder’s profit if less—and any profit in excess of that amount will be capital gain. While the exercise of an ISO is not an income event for regular federal income tax purposes, note that the difference between the exercise price and the fair market value of the stock at exercise is income for alternative minimum tax (AMT) purposes.
- If the option is a nonstatutory stock option (NSO)—also known as a nonqualified stock option—there’s no tax at grant or as the option vests. The option holder will have compensation income equal to the difference between the exercise price and the fair market value of the stock on the date of exercise and, upon sale of the stock, will have capital gain or loss equal to the difference between the sales proceeds and the value of the stock on the day of exercise. This capital gain or loss will be long-term if it was held for more than one year and otherwise will be short-term.
So far, so familiar.
Everything gets more complicated, however, if you want your employees to be able to exercise their options before they would otherwise vest. Mechanically, early exercising an option with an early exercise feature is straightforward enough: The option holder provides a notice of exercise to the company together with payment of the aggregate exercise price for the portion of the option being exercised and, in exchange, receives shares of restricted stock (generally, subject to the same vesting schedule that applied to the option award). Provided a Section 83(b) election is timely and properly filed within 30 days of exercise, the capital gains holding period (and, incidentally, the five-year holding period for Qualified Small Business Stock purposes) will begin at the time of exercise. Any AMT or compensation income will be recognized at the time the award is exercised and any increase in value will be capital gain. In this way, options with early exercise features give option holders the ability to start their capital gains holding period with respect to the stock underlying the option but ensure that the holders continue to stick around (and participate in company value creation) over the same period they would otherwise have vested in the option.
There are, however, significant tax traps for the unwary for both the option holder and the company, when it comes to early exercising stock options.
- Perhaps most significantly of all, contrary to popular belief, early exercising an ISO and timely filing a Section 83(b) election will not cause the capital gains holding period to begin for the shares. Rather, the capital gains holding period will begin the day after the restricted stock vests. While early exercising an ISO may have the effect of minimizing any AMT liability, if the purpose of early exercising a stock option is to kickstart the capital gains holding period, early exercising an ISO just doesn’t work.
- If a stock option is early exercised at a time when the fair market value of the underlying stock is higher than the option’s exercise price, there will be compensation income to the holder of an NSO (or AMT income to the holder of an ISO) at the time the Section 83(b) election is made. Any compensation income will be subject to all applicable income and withholding taxes and the company will have to ensure that the option holder can pay those withholding taxes. Note too that if the restricted stock is forfeited, the employee will not get a credit or refund of any (income or AMT) taxes paid as a result of making the Section 83(b) election.
- It is critical, when early exercising an option that the Section 83(b) election is properly and timely filed. If it is not timely filed, then (i) instead of having income at the time of making the election, there will be compensation income to the holder of an NSO (or AMT income to the holder of an ISO) equal to the difference between the purchase price (i.e., the exercise price paid) and the fair market value of the stock on each vesting date and (ii) the capital gains holding period will begin after the restricted stock vests. Again, any compensation income would be subject to all applicable income and withholding taxes (which the company must ensure can be satisfied).
- The ISO $100,000 limitation provides that if the shares of stock underlying an ISO that first become exercisable during any calendar year have a fair market value of more than $100,000, the excess shares of stock will be treated as if they were subject to an NSO. If an option is early exercisable, the entire award is “first exercisable” in the year of grant. As a result, fewer shares under an option may be eligible for ISO treatment if an option contains an early exercise feature (even if the option holder does not early exercise the option).
There are practical considerations too.
- When an employee early exercises a stock option, the employee becomes a stockholder for all corporate law purposes. If the company wants to limit the number of employee stockholders in the company’s cap table, that goal is undermined each time an option is early exercised.
- In order to early exercise an option, the option holder must pay the exercise price and any associated taxes. Because this cash is at risk, employees often don’t take advantage of broad-based early exercise programs.
- Instituting a practice of granting ISOs with an early exercise feature may lead to unintended tax consequences (see note above) but instituting a practice of only granting NSOs with an early exercise feature instead may not be as attractive to employees who do not intend to (or cannot afford to) early exercise their options (and would otherwise hope to benefit from ISO treatment).
- Unlike options which must be affirmatively exercised by the option holder to avoid being forfeited following a termination of service, the company must affirmatively act to repurchase restricted shares or the employee will retain them even after ceasing to perform services. Permitting early exercise of options requires that the company carefully track outstanding equity awards and adds administrative burdens to the stock plan administrator.
Certainly, the ability to early exercise a stock option may give certain employees a tax advantage. However, the tax considerations and practical implications of granting options with (or amending outstanding options to add) an early exercise feature are much more complex than would appear at first blush. It may be, for example, that the same goals can be achieved more simply by granting an award of restricted stock from the get-go. (And if the thought of making grants of restricted stock is not palatable to the company, then granting options with an early exercise feature may not be for you at all.)
We touch on some of the significant issues of early exercising options in this post, but any program or practice of granting options that can be early exercised (whether on a case-by-case basis or across the board) should be carefully reviewed with tax counsel.
