Exercising stock options means buying shares. Early exercising stock options means buying the stock before it vests. When should you exercise an option early? In the right situations, early exercising stock options can reduce tax when paired with an 83(b) election. And if you have incentive stock options (ISOs), it may be a way to avoid triggering the alternative minimum tax (AMT). An early exercise starts the holding period for long-term capital gains. For some startup employees, it could be the key to qualifying for tax-free stock sales down the road.
Early Exercise Stock Options, Key Summary:
- An early exercise of stock options allows buying shares before they vest, which can reduce taxes when coupled with an 83(b) election
- Exercising stock options early can help lower AMT or avoid it entirely for incentive stock options and start the holding period for long-term capital gains
- Early exercising can be key to ensuring your shares meet the criteria for qualified small business stock (QSBS)
- Risks include job loss complications, lack of liquidity, fluctuating stock prices, and cash concentration risks
- It’s crucial to consider personal financial situations and market conditions before deciding to early exercise stock options
It doesn’t always make sense to early exercise unvested options, so it’s important to understand the risks, pitfalls, and tax implications first.
Before getting into the pros and cons of early exercises, a word of caution. Employees with stock options often focus on one thing: taxes. And specifically, how to reduce them at all costs. Don’t fall into this trap. Sometimes, exercising options early is a terrific opportunity; other times it’s a terrible idea. Before swooning over the glimmer of potential tax savings, understand the risks, rules, and ways this approach could backfire.
What is an early exercise of stock options?
In most stock plans, option grants vest over time and exercising isn’t possible until shares vest. An early exercise of stock options means buying the shares before you vest. The potential tax savings can be huge.
Early exercising stock options won’t change the vesting schedule. So employees with equity compensation still need to earn their startup equity. Exercising early also won’t change your purchase price or expiration date of the company stock grant.
However, when everything goes according to plan, exercising options early has the potential to drastically reduce taxable income compared to a typical exercise.
The reason is simple: if the valuation keeps going up, so does the spread above your strike price. The larger the gap, the harder it is to exercise stock options at a private company and the more you’ll pay in tax as a result (all else equal).
This article has more on regular stock option exercises.
Understanding the potential benefits of early exercisable employee stock options requires knowledge of how stock options are taxed. In the typical scenario, there are no tax implications at grant or vesting.
Should I early exercise ISO or NSO stock options?
For ISOs, when the strategy goes according to plan, there’s an opportunity to reduce or eliminate AMT. It can also start the clock early for a qualifying disposition on shares that may not vest for several years.
For NQSOs, the opportunity is typically much better. The early exercise of non-qualified stock options has the possibility to achieve the tax benefits of ISOs with a 1-year holding period and without AMT concerns.
An early exercise might be a good idea when:
- Shares currently qualify for Section 1202, qualified small business stock as the exercise date starts the 5 year clock (partial exclusions start at 3 years for purchases after July 4 2025)
- Spread between the exercise price and FMV is zero
- Company is unlikely to be acquired before the holding period is met
- You have enough cash on hand to buy the shares and pay any tax due – without selling the stock
- You are confident about the growth of the company and the likelihood of a future IPO or liquidity event
Early exercise stock options tax treatment
Early exercises can offer significant tax savings in certain situations. Because the employee is buying unvested stock, the income tax treatment is different than a typical exercise.
83(b) election with an early exercise
With an 83(b) election, taxpayers accelerate the tax impact for income tax purposes or the AMT. Here’s why: at grant, the strike (purchase) price usually equals the current fair market value of the stock. If you exercise immediately with an 83(b) election, there’s an opportunity to have no spread between the FMV and strike price.
Early exercising NSOs using an 83(b) election means you could reach the long-term capital gains holding period a year post-exercise. For ISOs, there are special requirements for the gain to be taxable as a long-term capital gain: you must own the shares for 2 years from grant and 1 year from early exercise.
See our detailed guide for examples of early exercise tax treatment with and without an 83(b) election.
Video: Early Exercising Stock Options (Examples)
Financial Advisors Specializing in Stock Options
Early exercise risks
There are several serious risks when exercising unvested shares of company stock. Here are a few to consider.
- If you leave your job with unvested shares. The company can repurchase the stock at the lesser of your strike price or the current FMV. You don’t get a refund on the tax paid.
- No liquidity event. At a private company, there’s no liquid market to sell stock. There’s no guarantee there will ever be an exit, tender offer, or secondary market. Exercising options at a startup can be the easiest to do financially (low strike price = lots of potential upside). But it’s also the most unclear as to the longevity and path of the business.
- Stock price/valuations decline. Regardless of whether there’s a public market for the stock or not, the value of a company doesn’t just go up. Especially if considering an exercise before an IPO, the private valuation may be higher than what the public market thinks it’s worth. Further, your taxable spread could be very large, making an exercise-and-hold all practically impossible.
- Cash and concentration risk. Exercising options can sometimes require a significant cash outlay to buy the shares and possibly pay tax. Robbing your emergency fund or taking out a loan only increases your risk. Also consider your overall concentration and liquidity. Serial startup employees may have private shares with past companies. This creates a situation that’s very illiquid and concentrated in a few companies.
- M&A can ruin your plans. The IRS doesn’t care why you have a disqualifying disposition or short-term capital gain. If your company is bought or acquired before your holding period is met, there may be negative tax implications. Note: unexercised ISOs can be considered cancelled options in some buyouts, triggering payroll taxes.
What’s the best exercise strategy?
In certain circumstances, like when the cash outlay (purchase price + tax) is small and manageable, early exercising can be a huge opportunity. In other situations, waiting to exercise employee stock options until there’s certainty can be a good approach. Especially if the goal is diversification, knowing the tax impact and net profit helps decision-making.
Further, after an IPO, there are often other ways to purchase the stock, such as a cashless or net exercise. Public markets offer liquidity, after the lockup expires. When considering the pros and cons of any exercise strategy, don’t let the tax tail wag the dog.
Let’s Talk About Your Equity.
If a liquidity event is on the horizon and you want an advisor in your corner for the long haul — let’s talk.
Early exercise FAQ
An early exercisable stock option allows employees to exercise their right to buy shares before they vest. Exercising unvested options is called an early exercise.
All else equal, NSOs are better for early exercises than ISOs because you’ll reach long-term holding periods one year after exercise. But if there’s a spread between your strike price and the current value of the stock, ISOs might be better from a cash flow perspective because NSOs have tax withholding requirements.
Early exercising ISOs when the strike price is equal to the FMV of the option and an 83(b) election means the spread for AMT tax purposes is $0. There are no federal tax implications at exercise. At sale, if the ISO holding period is met (2 years from grant, 1 year from early exercise), the entire gain is a long-term capital gain.
If you don’t make an 83(b) election when exercising incentive stock options early, there are no tax implications at the time of exercise for AMT or federal tax. But when the shares vest, the spread between the strike price and fair market value at vesting is income for AMT. To meet the terms for a qualifying disposition, you’ll need to hold the shares for 1 year after the shares vest (not when you early exercised) and 2 years from the grant date.
Regardless of whether you made an 83(b) election, if the sale of ISOs is a disqualifying sale, the tax treatment is likely to be the same had you filed. Although IRS guidance isn’t 100% clear, many tax professionals agree that in the event of a disqualifying disposition of early-exercised incentive stock options, the spread between the fair market value of the stock at vesting and the strike price is ordinary income for federal tax purposes. Any subsequent gain or loss is a capital gain/loss, based on the holding period after vesting and the spread between the sale price and the FMV at vesting.
At exercise, the difference between the fair market value and the NSO strike price is taxable as ordinary income and subject to payroll tax. It begins the 1-year holding period requirements for long-term capital gains tax treatment. So if the stock vests and is sold more than a year and a day after the shares were exercised, you’ll have a long-term capital gain.
If you fail to file an 83(b) election when exercising NSOs early, there are no tax implications until the stock vests. At vesting, the spread between the exercise price and the fair market value at vesting is taxable. The capital gains holding period begins when the stock vests.
This article is for informational purposes only and not to be misinterpreted as personalized advice or a recommendation for any specific investment product, strategy, or financial decision. This article does not contain sufficient information to support a financial or investment decision. If you have questions about your personal situation, consider speaking with a financial or tax advisor.
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