TL;DR
If your company's stock rises in value over the years, you can avoid two major tax issues by executing an early exercise along with filing an 83(b) election.
What does it mean to early exercise stock options?
Early exercising stock options refers to the act of purchasing company shares before they fully vest, allowing employees to acquire ownership at an earlier stage. By choosing to exercise their stock options early, employees take advantage of the opportunity to buy shares of the company while the valuation is low. This decision can offer potential advantages such as favorable tax treatment and the potential for greater long-term returns, but it also carries risks and considerations that individuals need to carefully evaluate before proceeding. It is also worth noting that early exercise must be supported by your company and is not always an available option.
Why file an 83(b) election?
Venture-backed startup companies are big fans of using stock options as a major compensation tool to attract and retain employees. By opting for early exercise, you can potentially avoid two major tax issues: 1) taxes at exercise and 2) starting the clock on long-term capital gains. This all assumes the value of your company's stock rises over time.
Filing an 83(b) election with the IRS within 30 days of your early exercise date is crucial to establish your actual purchase date and recognize the taxable value of your assets. This proactive step ensures that your exercise remains tax-efficient and positions your investment for long-term capital gains treatment. If you do not file an 83(b), the IRS doesn't recognize un-vested shares as income until they vest. You do not have to pay taxes upfront, but rather as the shares vest over time. This protection works against your ability to recognize future income as long-term capital gains as the clock would not begin until vesting of the shares, essentially defeating the purpose of exercising early.
How to file an 83(b) election:
There is no special form for filing an 83(b) but you can download a sample from us. You are cautioned to review this with your tax advisor for compliance with your particular situation and since IRS rules are continually subject to change. Send 2 copies to the IRS along with a self-addressed stamped envelope for them to return a stamped acknowledgment. Also file one with your actual tax return in addition to keeping one copy for your records. Although this subsequent filing requirement has gone away in recent years to encourage e-filing, please check with your tax professional before skipping the filing. Exercising stock options early or voluntarily paying taxes on a large block of RSUs can require a lot of capital and yet the time to liquidity for your company can be quite long. Follow this link for a summary of other ways to reduce your stock option taxes.
As your shares are vested, you may be tempted to sell some shares to recover your original investment or perhaps fund other financial needs. Be aware that a sale is a taxable event and it also truncates any possibility of future upside on the shares being sold. An alternative solution for partial liquidity is to get funding from the ESO Fund. This is an attractive solution because no payments are due until a liquidity event is reached on the stock. Furthermore, if the stock becomes worthless, ESO absorbs the loss, not you.
For more information, please contact us at the ESO Fund.
