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Early Exercising and 83(b) Elections

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9min read
TL;DR: Some employers allow their employees to exercise their stock options before they fully vest so employees can save on taxes. If your employer does allow you to early exercise and you decide to do it, remember to file an 83(b) election with the IRS in order to verify that you purchased the options and are including it as income within that tax year (instead of in the future when it vests). You do this by filling out a simple form and mailing it to the IRS within 30 days from the date of exercise. Failure to file this form could result in you owing much more in taxes down the line and perhaps at inconvenient times.

When you exercise, you get taxed on the spread between your strike price (what it cost to buy them) and the company's most recent price per share of common stock. If you've waited years to exercise, that spread can potentially be quite large, and land you with a huge tax bill that you may not have the liquidity to cover.

Early Exercising

The IRS generally requires that employee equity be included as gross income in the year it vests. However, the IRS allows for an election to include that income in the year of transfer (in your case—if the shares have been purchased, but are still vesting). In the case of early exercise, this is the crux of how you save on tax; the year of transfer is when you early exercise, while the year of vesting is later (depending on the vesting schedule of your options). 

If you are very optimistic about the long-term value of your equity, you should consider exercising your options as early as possible to reduce tax exposure. Due to how options are taxed and the hyper-competitive market for startup talent, an increasing number of companies are allowing employees to purchase all of their unvested stock options upfront through early exercise programs. If you exercise early enough, while there is no spread, you would owe no taxes at all from the exercise. Furthermore, you would be eligible to convert all future appreciation into capital gains rather than ordinary income. 

To ensure you get to enjoy that tax benefit, make sure you’ve filed the right paperwork with the IRS, including something called an 83(b) election.

What are the benefits of early exercising your stock options?

  • Ordinary income tax minimization - Stock options are generally taxed on the bargain element (the spread between the strike price of the option at the time of exercise) and the fair market value (often indicated by a 409A valuation, which is an independent appraisal of the fair market value of a private company's common stock). When you’re granted your options, the 409A valuation and strike price are usually the same value, meaning you aren’t generating any income (or tax) if you exercise at that time. As your company becomes more valuable, that spread increases, as does any potential income you’ll generate if you exercise your stock options so exercising early can save you a meaningful amount on taxes you’ll eventually owe.

Let’s take a hypothetical scenario:

Say you’re a Single California Resident with a $150,000 salary and 10,000 ISOs early exercisable with strike price of $1.

Here’s the same scenario but with NSOs:

[0] see bottom of article for glossary of terms. You can also read more about AMT here.

Early exercising your options in both scenarios would save you thousands in additional federal and state taxes.

  • Starting your holding period for capital gains - Early exercising stock options may start your holding period—the duration of time between the acquisition of an asset and its sale—for that equity. This can be beneficial for capital gains tax, which allows for a preferential tax rate (either 0%, 15%, or 20% compared to regular tax, which is up to 37%, depending on your income) if ISOs are held for longer than two years from date of grant and one year from date of exercise. (If you early exercise as soon as you are granted your options, you still need to hold them for a minimum of two years before you can sell them for preferential treatment.) Depending on your company, early exercising may allow your stock to qualify for QSBS treatment as well, which doesn’t otherwise apply to options.
  • Peace of mind - If you early exercise, you make one decision and are set, rather than having multiple decisions to make later on that are affected by vesting, 409A updates, and new tax calculations with 409A updates.

What are the downsides of early exercising stock options?

  • Cash needs - When exercising your stock options, consider first whether you have access to the funds needed to exercise your equity. Not only do you need to pay the strike price, but depending on the structure and current spread of the options, you may either need to pay taxes immediately if you have Non-qualified Stock Options (NSOs) or may have taxes due later in the year if you have Incentive Stock Options (ISOs) due to the application of the alternative minimum tax regime. You can read more about the difference in our guide to stock options.
  • Limited liquidity - Private stock on the secondary market is generally not liquid. Once you vest your equity, you may still struggle to find a chance to sell some or all of your stock. Often, early employees or founders need to wait until there is a specific event, such as a secondary sale, company sponsored share buyback, IPO, or acquisition before they have a chance to sell their equity. In other words, your capital is tied up for a longer period than if you’d have waited to exercise at a later point.
  • Leaving unvested stock - If an employee exercised all their equity, but leaves before half of the vesting is complete, they are usually subject to restrictions that require them to re-sell the equity to the company at whichever is lower—the amount originally paid or current fair market value. If the taxpayer’s options had a spread and they paid tax at exercise, they do not get to take a loss—which can lower your tax total liability—on the amount returned to the company. This makes the decision of how much equity to early exercise and when to leave a company a more complicated decision.
  • The company may fail - Part of the beauty of options is you don't need to pay a cent until there is realizable value. The longer you wait to exercise, the more information you can accumulate about the likelihood and magnitude of a potential exit opportunity. This is valuable—startups may fail and success is hard to predict. At the same time, waiting to exercise may increase your tax exposure (as discussed above) and the likelihood of a disqualifying disposition if your options are ISOs. Additional external factors, such as dilution and liquidation preferences, may also impact your decision.
  • Complex ISO tax treatment –  A disqualifying disposition occurs when the optionee sells the shares (including from certain mergers, over which the employee has no control) within two years from the grant date or one year from the exercise date. In this scenario, potentially adverse consequences arise. If you are not subject to the alternative minimum tax and have a disqualifying disposition, you will be subject to tax on sale in two forms: (1) ordinary income tax on the spread between the strike price and the value of the shares at the later of exercise and vesting and (2) any excess gains will be taxed as capital gains (based on whether you held the shares for more than one year from the later of exercise and vesting).  In this scenario, your Section 83(b) election had no effect since you were effectively taxed at ordinary income rates at vesting, just paying that tax at sale. If you are subject to the alternative minimum tax, your 83(b) election is given effect. If you sell within the same year as exercise, you will have ordinary income to the extent of the spread at exercise and the remainder gain from sale will be capital gains. If you sell in the year after exercise in a disqualifying disposition,, but paid AMT in the year of exercise, you may be able to apply an AMT carry forward to offset that ordinary income.

It is also worth flagging one particularly risky point with early exercising. In bust-boom economic cycles, many employees exercise in one year when the economy is strong and the employee finds him or herself in the alternative minimum tax (due to higher incomes and high spreads on exercise). The stock then declines in value in the next year and the company sells for a fraction of the previous value. Here, the employee paid AMT taxes in one year on gains ultimately never realized in cash and the IRS does not give that money back.

When and why would I file an 83(b) election?

If you decide to early exercise a portion or all of your options, you’re not in the clear for tax yet; you need to file a form called an 83(b) election with the IRS.

The 83(b) election is a simple form submitted to the IRS to let them know you have elected to pick up the income of the equity received at the time of purchase, rather than when it vests. You have 30 days from the date of exercise to complete and submit an 83(b) election. There are no extensions or exceptions to this rule. In other words, if you early exercise and do not file an 83(b) in time, you do not get any of the tax benefits of early exercising.

Generally, your equity manager (Carta, Shareworks, Pulley, etc.) or the legal team for your company should help you generate the 83(b) election form when you exercise your options, though you should have your personal CPA review the completed election before you submit it. But please note that the Section 83(b) election is your responsibility and no one else’s.

To complete the filing, you need to:

  • Submit a completed 83(b) election (along with a copy) to the IRS. Please be sure you are filing with the proper IRS service center for your region, as indicated on the instructions to the Section 83(b) form.
  • Include a self-addressed and stamped envelope and instructions for the IRS to stamp and return a copy for your records. Here’s a template for the instructions to include.

Make sure to keep records of your 83(b) election, including certified mail receipts and a copy of the election form, in case you need it in the future. You must then provide evidence of this mailing promptly to your employer and may want to consider attaching a copy to your individual state and federal tax returns for the year in which the filing occurred.

FAQ

Q: What happens if I early exercise and then leave the company before all my options vest?

A: If any of the options you exercised are still unvested when you leave your job, the company has to pay to repurchase those shares from you. Check your grant agreement and any other agreements that govern your options (such as a stock plan) to see how long the company has to repurchase the shares and how much they have to pay you (usually the lower of what you paid or the fair market value of the shares on the day of repurchase).

Q: I purchased shares outright when I founded my company, but am now raising a new round and my investors are asking me to subject myself to vesting. Do I need to file an 83(b) election?

A: No. Because you already owned the shares, there has been no transfer of shares in connection with services. However, many employees still file a protective election, as certain large financings may be viewed as changes of control, in which case a Section 83(b) election would be required.

Q: My company was acquired in a tax-free reorganization (where the stock in the prior company is being exchanged for stock in the new company), and I received stock in the new company in exchange for my previously purchased shares. As part of the deal, the new shares are subject to a new vesting schedule. Do I need to file an 83(b) election?

A: Yes. Because you are receiving a new transfer of property, which has a risk of forfeiture (meaning the equity is still not entirely yours and there is still substantial risk you might lose it), you need to file a new 83(b) election for the shares.

Q: Can I correct an 83(b) election if I made a mistake when I originally submitted?

A: The short answer is no. Taxpayers have the ability to revoke an 83(b) election, but only with the consent of the IRS, and there must have been a mistake of fact regarding the transaction. Mistake of value, decline in value, or failure to perform an action is not considered a “mistake of fact.”

Q: Can I file an 83(b) election on my Restricted Stock Units (RSUs)?

A: No. Because you do not receive the stock until the RSU vests, there isn’t a current transfer of property.

Q: What happens if I miss the 30-day window to file my 83(b)?

A: You have 30 days from the date of exercise to complete and submit an 83(b) election. There are no extensions or exceptions to this rule. If the 30th day following the date of exercise falls on a Saturday, Sunday or legal holiday, the election will be considered timely filed if it is postmarked by the next business day.

[0] Glossary of Terms

AMT Deferral Amount - This is the amount of AMT preference added to the AMT calculation. It consists of the value at the time of exercise minus strike price, multiplied by the total amount of shares exercised. 

AMTI - This stands for Alternative Minimum Taxable Income. It’s all the AMT income items used to compute AMT tax. In our example, the wages plus any AMT deferral amount makes up the AMTI. 

Additional Federal AMT or Additional CA AMT - AMT is calculated every year alongside ordinary tax. In years when you have enough AMTI to trigger more AMT than ordinary tax, the amount of AMT that is greater than the ordinary tax is added to your return in addition to the ordinary tax amount. In our example, these amounts are the additional tax you must pay on top of your ordinary income tax assuming you did not exercise the options.

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