Not So Fast…the (Unexpected) Consequences of Allowing Your Employees to Early Exercise Options
From time to time, and primarily when the economy is booming, allowing to be “early exercised”—that is, allowing to be exercised before they are vested—becomes in vogue. We are in one of those times. Ordinarily, the holding period for the underlying an option begins when the vested
To set the stage, it helps to understand how regular stock options are used and how they are taxed.
To ensure that the option holder actually participates in company value creation, the right to exercise a
As we’ve described elsewhere, the tax consequences of this form of compensation depend on the type of option that has been granted.
- If the option is an incentive
stock option(ISO), there is no tax at , as the optionvests, or at exercise. If the optionholder holds the stockreceived upon exercise until a date that is more than two years from the date of grantand one year from the date of exercise, the difference between the sale price and the will be long-term capital gain(or loss). If either of those holding periods is not met, then at the time the stockis sold the optionholder will have compensation income equal to the difference between the fair market value of the stockat exercise and the exercise price—or the optionholder’s profit if less—and any profit in excess of that amount will be capital gain. While the exercise of an ISO is not an income event for regular federal income tax purposes, note that the difference between the exercise priceand the fair market value of the stockat exercise is income for alternative minimum tax (AMT) purposes.
- If the option is a nonstatutory
stock option(NSO)—also known as a nonqualified stock option—there’s no tax at grantor as the optionvests. The optionholder will have compensation income equal to the difference between the exercise priceand the fair market value of the stockon the date of exercise and, upon sale of the stock, will have capital gainor loss equal to the difference between the sales proceeds and the value of the stockon the day of exercise. This capital gainor loss will be long-term if it was held for more than one year and otherwise will be short-term.
So far, so familiar.
Everything gets more complicated, however, if you want your employees to be able to exercise their options before they would otherwise vest. Mechanically, early exercising an
There are, however, significant tax traps for the unwary for both the option holder and the company, when it comes to early exercising
- Perhaps most significantly of all, contrary to popular belief, early exercising an ISO and timely filing a will not cause the capital gains holding period to begin for the shares. Rather, the
capital gainsholding period will begin the day after the restricted stockvests. While early exercising an ISO may have the effect of minimizing any AMT liability, if the purpose of early exercising a stock optionis to kickstart the capital gainsholding period, early exercising an ISO just doesn’t work.
- If a stock option is early exercised at a time when the fair market value of the underlying
stockis higher than the option’s exercise price, there will be compensation income to the holder of an NSO (or AMT income to the holder of an ISO) at the time the Section 83(b) election is made. Any compensation income will be subject to all applicable income and withholding taxes and the company will have to ensure that the optionholder can pay those withholding taxes. Note too that if the restricted stockis forfeited, the employee will not get a credit or refund of any (income or AMT) taxes paid as a result of making the Section 83(b) election.
- It is critical, when early exercising an option that the Section 83(b) election is properly and timely filed. If it is not timely filed, then (i) instead of having income at the time of making the election, there will be compensation income to the holder of an NSO (or AMT income to the holder of an ISO) equal to the difference between the purchase price (i.e., the
exercise pricepaid) and the fair market value of the stockon each vesting date and (ii) the capital gainsholding period will begin after the restricted stockvests. Again, any compensation income would be subject to all applicable income and withholding taxes (which the company must ensure can be satisfied).
- The ISO $100,000 limitation provides that if the shares of stock underlying an ISO that first become exercisable during any
calendaryear have a fair market value of more than $100,000, the excess shares of stockwill be treated as if they were subject to an NSO. If an optionis early exercisable, the entire award is “first exercisable” in the year of . As a result, fewer shares under an optionmay be eligible for ISO treatment if an optioncontains an early exercise feature (even if the optionholder does not early exercise the option).
There are practical considerations too.
- When an employee early exercises a stock option, the employee becomes a
stockholderfor all corporate law purposes. If the company wants to limit the number of employee stockholdersin the company’s , that goal is undermined each time an optionis early exercised.
- In order to early exercise an option, the
optionholder must pay the exercise priceand any associated taxes. Because this cash is at risk, employees often don’t take advantage of broad-based early exercise programs.
- Instituting a practice of granting ISOs with an early exercise feature may lead to unintended tax consequences (see note above) but instituting a practice of only granting NSOs with an early exercise feature instead may not be as attractive to employees who do not intend to (or cannot afford to) early exercise their options (and would otherwise hope to benefit from ISO treatment).
- Unlike options which must be affirmatively exercised by the
optionholder to avoid being forfeited following a termination of service, the company must affirmatively act to repurchase restricted shares or the employee will retain them even after ceasing to perform services. Permitting early exercise of optionsrequires that the company carefully track outstanding equity awards and adds administrative burdens to the stockplan administrator.
Certainly, the ability to early exercise a stock option may give certain employees a tax advantage. However, the tax considerations and practical implications of granting
We touch on some of the significant issues of early exercising options in this post, but any program or practice of granting