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. This allows employees to acquire ownership of unvested stock at an earlier stage. By early exercising, employees take advantage of the opportunity to buy shares of the company while the valuation is low. Worth noting, if the employee leaves the company, any unvested shares will be bought back at cost.
This decision can offer potential advantages such as favorable tax treatment and greater long-term returns. However, it also carries risks and considerations that individuals need to carefully evaluate before proceeding. In order for this to be an option, your company must support early exercise, which is not always the case.
Why exercise early?
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:
2) starting the 1-year holding period on long-term capital gains
This all assumes the value of your company's stock rises over time.
Taxation of stock options at exercise is based on the difference between the current Fair Market Value and their Strike Price. Early exercising immediately after receiving a grant almost certainly ensures that you will pay $0 in exercise taxes. This is because the FMV and strike price are likely the same number.
Over time as the FMV rises, early exercise becomes less favorable. It will still however lock in your taxes on the date of exercise.
Early exercise also allows you to start the clock on long-term capital gains before the shares even vest. In a case where liquidity is imminent this can mean up to almost 20% in tax savings. This depends of course on your bracket and state.
Both of these benefits of early exercise really heavily on one item: filing an 83(b).
Why file an 83(b) election?
Filing an 83(b) election with the IRS within 30 days of your early exercise date is crucial. This establishes your actual purchase date and recognizes 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 and subjects. This essentially defeats 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.
Since IRS rules are subject to change, you are cautioned to review this with your tax advisor to ensure compliance with your particular situation. Send 2 copies to the IRS along with a self-addressed stamped envelope for them to return acknowledgment. Also file one with your actual tax return in addition to keeping one copy for your records.
Exercising stock options early can require a lot of capital and time to liquidity can be lengthy. As your shares vest, you may be tempted to sell to recover your original investment or fund other financial needs. However, a sale truncates any possibility of future upside on the shares being sold.
An alternative solution for partial liquidity is to get an advance from ESO Fund. This is an attractive solution since you retain ownership of the stock plus the ability to achieve unlimited upside. Furthermore, if the stock becomes worthless, ESO absorbs the loss, not you. Feel free to reach out using our contact form below if you have any questions.
For more information, please contact us at the ESO Fund using the form below.