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Some companies grant stock options that are immediately exercisable, but
you receive shares that still need to vest before you own them
outright. Until then, the stock is still subject to a repurchase
right if your employment ends before vesting. Check your grant
agreement for whether your options are immediately exercisable at grant
before vesting, and check the repurchase details. At some companies this
is called a restricted stock purchase plan or early-exercise
stock options.
This technique is used mostly by startup and private companies
(though only 4% of companies surveyed by the NASPP in 2007).
Early-exercise options with a repurchase right let employees who wish to
make an early investment decision about the company start their capital
gains holding period sooner. If you hold the stock, not just the
options, for at least 12 months, you will pay lower taxes on the later
sale. In a private company, the downside
is that the shares have no liquidity (i.e., are not tradable even when
vested). You may be holding the shares for an indefinite period until
any IPO or acquisition or until the shares become worthless.
When the spread is zero or negligible, early exercise also
minimizes the chance of any alternative minimum tax on ISOs, and
ordinary income for NQSOs on the spread at exercise. The plan needs to
allow you to exercise your options immediately into stock, which the
company can buy back at your exercise price (or another price your plan
specifies) if you leave within the original vesting period.
What Happens At Early Exercise
At exercise, you have essentially purchased restricted stock.
(This should not be confused with an acquisition of restricted
securities which, under the securities laws, cannot be immediately
resold. For more on the difference, see a related
FAQ.) You should make a Section
83(b) election and file it within 30 days of exercise with the
Internal Revenue Service and with your next tax return.
Alert: In this situation, you make a Section
83(b) election even when you have paid the fair market value for the
restricted stock and there is no discount or spread. You report that you
have zero income for the value of the property received. Otherwise, you
will owe ordinary income later on the stock's appreciation in value
between purchase and vesting (see the case of Alves
v. IRS Commissioner, decided in 1984).
Tax Treatment For Early Exercise
The election essentially says that you agree to recognize as
ordinary income for NQSOs, and as an AMT item for ISOs, any spread
between the stock's fair market value and your exercise price. In this
way, the future appreciation on the NQSO stock can be taxed at favorable
long-term capital gains rates at the sale of the underlying stock.
Without the timely Section 83(b) filing at exercise, you recognize the
income on the spread at vesting for both ISOs and NQSOs.
As explained in another FAQ,
the ISO taxation is more complex for early-exercise options with an
83(b) election. For this special type of ISO, the one-year ISO holding
period begins at exercise. But in a sale before the ISO holding periods
are met (i.e., disqualifying disposition in a sale within two years from
grant), the ordinary income is the lower of either the spread at
vesting (remainder is capital gain) or the actual sale gain.
Status Of Your Shares After Exercise
The period for the company's repurchase right is similar to the
cliff or graduated vesting schedules for traditional stock options. In
exchange for the potentially lower tax on sale of the stock, you do
commit money to your company's stock earlier. Although the unvested
shares you receive upon purchase/exercise may be held in an escrow
account until they vest, they are outstanding shares that confer voting
rights and eligibility for dividends. Occasionally, when permitted by
law, companies offer loans
to employees to encourage this early exercise.
Alert: You do not need to make this filing for
standard stock options that you can exercise only after vesting. The
stock you receive at the exercise of vested stock options is not subject
to a substantial
risk of forfeiture that triggers the ability and need to make a
Section 83(b) election.
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