Tax Considerations for Early Exercising ISOs

When granting incentive stock options (ISOs) to employees, some companies allow for the possibility of “early exercising.” This is a choice that the employee is offered that would allow him/her to exercise all or a part of the option grant upfront, rather than wait until vesting. In other words, early exercising is the ability to purchase shares of stock in the employer’s company before the employee’s ISOs vest.

Many clients turn to us for tax advice before making their decision, which is appropriate given the benefits of early exercising are entirely tax-related. But it is not solely a tax optimization problem, as the drawback is the investment risk that each startup employee has to weigh against their personal risk tolerance and broader financial goals.

This article explains the basic trade-offs of early exercising from a tax perspective. Due to the complexity surrounding stock options, we recommend that everyone speak with a tax advisor as each person’s financial situation is unique.

What is “Exercising” an ISO?

An incentive stock option goes through five phases:

  1. the employer grants ISOs to the employee;
  2. then the ISOs vest on the schedule indicated in the initial grant document;
  3. then the employee exercises an ISO, which means buying shares of stock in the employer’s company at a predetermined price, known as the “strike price”;
  4. then the employee holds onto the stock for a period of time; and
  5. then the employee sells the stock.

Exercising an ISO, step 3, involves purchasing stock in the employer’s company at the strike price. Normally, an employee can exercise their ISO only after the option vests.

What is “Early Exercising” an ISO?

With an early exercise, the employer gives the employee an opportunity to purchase stock in the employer’s company at the strike price before the ISO vests.

In other words, an early exercise switches steps 3 and 2 in the five phases spelled out above.

Remember, not all companies will allow employees to do this. The grant document will specify whether early exercising is allowed under your employer’s equity plan.

When does Early Exercising make sense?

Strictly from a tax perspective, early exercising makes sense if the employee can afford the cost of the transaction. The cost of the transaction is the cost to exercise the option plus any tax costs.

The employee will need to balance their tax concerns with other factors, such as how much they can afford to invest, and whether this investment makes sense for their situation.

The Benefit of Early Exercise

The primary benefit of exercising early is to exercise when the fair market value of the ISO is equal to the strike price. That way, the client has no additional tax cost for the early exercise.

Exercising an ISO also starts the clock ticking on the holding period. If the stock is held more than one year from the exercise, then the gains on that stock are taxed at the lower tax rates for long-term capital gains. The capital gains rates are zero percent, 15% and 20%.

The Drawbacks of Early Exercise

The primary drawback of an early exercise is the financial risk the investment will decline in value. If the company ends up failing, you could lose your entire investment.

Another drawback is that the employee will not be fully vested in their shares. Shares of stock will continue to vest according the the original vesting schedule. If the employee stops working for the company, they might have to sell their unvested shares back to the company at the strike price. That opens the possibility that the employee could have paid tax on stock that the employee does not get to keep.

What are the Tax Impacts of Early Exercising an ISO?

The key factors in determining the tax impact of exercising an ISO are the fair market value of the ISO and the strike price (also called the exercise price) of the ISO.

When the market value of the ISO is equal to the strike price, which occurs when the ISOs are first granted, there is no tax cost for exercising the ISOs, as long as the employee also files what’s known as an 83(b) election.

When the market value of the ISO is greater than the strike price, on the other hand, then the difference between the two amounts is treated as additional income subject to the Alternative Minimum Tax.

Why File an 83(b) Election when Early Exercising?

Generally speaking, we recommend that clients file an 83(b) election whenever exercising their ISOs early. The deadline for making an 83(b) election is 30 days from the exercise date.

To understand why, we need to understand how the spread or bargain element of the ISO is taxed. The spread or bargain element is the difference between the value of the ISO and the strike price to exercise the option.

With an 83(b) election, the spread is immediately taxable on the early exercise date for the difference between the value of the option on the exercise date and the option’s strike price. In other words:

(FMV of ISO on Early Exercise Date – Strike Price) x Number of ISOs exercised

Without an 83(b) election, the spread is taxable when the underlying stock vests. This happens according to the original vesting schedule for the options. But there’s a second change: the spread is calculated using the value of the option on the date the stock vests. In other words:

(FMV of ISO on Vesting Date – Strike Price) x Number of ISOs exercised

Let’s take a simple illustration so we can see what this looks like.

Example 1. Erick works for an early stage start-up company. The company grants him 10,000 incentives stock options with a strike price of $1. Erick exercises his options early when the fair market value of the ISO is still at $1, and makes an 83(b) election for this transaction. Because the market value of the stock option on the exercise date is equal to the strike price, Erick has no taxable income to report from this early exercise. His total cost for the exercising all his ISOs early is $10,000.

Example 2. Sandra works for the same early stage start-up company as Erick does. Unlike Erick, Sandra decides to exercise her ISOs when they vest instead of early exercising. Assume the same facts as Erick’s situation: the company grants Sandra 10,000 incentive stock options, also with a strike price of $1. One-quarter of her ISOs vest one year after the company granted the ISOs. Sandra exercises 2,500 vested options, and on that day the options have a market value of $2. Sandra has taxable income of $2,500, which is the spread between the market value and the strike price (($2-$1) x 2,500 ISOs). A similar situation will happen on future years: when the remaining ISOs are exercised, Sandra will pick up taxable income for the difference between the market value of the ISO on the day of exercise minus the strike price.

Thus if an employee waits to exercise, there is the possibility that the value of the company’s stock could increase, and this could trigger tax costs when the employee does decide to exercise.

What is this Alternative Minimum Tax?

The income from the bargain element can push a person’s taxable income for Alternative Minimum Tax (AMT) purposes to the point where the tax as calculated under the AMT rules is higher than the tax under the regular rules.

The AMT is a secondary method of calculating someone’s tax liability. The mathematical idea behind the AMT is fairly straightforward. A person’s tax liability for any particular year is the higher of the tax as calculated under the regular system or the tax as calculated under the AMT system.

For regular tax purposes, we add up all items of income, then subtract out deductions, and what’s left over is taxable income. On this taxable income, we calculate the tax liability using the regular tax rates ranging from 10% to 37%.

The AMT works exactly the same way as the regular calculation. We add up income and subtract deductions to find taxable income, and then multiply this against the AMT tax rates of 26% and 28%. But the tax rates are not the only difference. Some items count as income for AMT purposes that don’t count as income for regular tax purposes. The bargain element of an ISO — the spread between the value of stock and the strike price — is included as income for AMT purposes, even though this is not counted as income for regular tax purposes until the stock is sold.

Tax Impact when Selling Shares

When the employee sells their shares of stock, the increase (or decrease) in the value of the stock is taxed as income. To figure out the tax impact, we need to measure the length of time the person has owned the stock.

If a person has owned that stock more than 2 years from the date the incentive stock options were first granted and more than 1 year from the exercise date, then all of the increase in value of the stock is treated as long-term capital gain. That means the gain will be taxed at the rates used for long-term gains — at zero percent, 15% or 20% — which is lower than the rates used for other types of income, which range from 10% to 37%.

If a person does not own the stock long enough to meet this holding period requirement, then some of the gain will be treated as additional compensation, which is taxed at the normal tax rates instead of the lower capital gains rates.

The Bottom Line

On the one hand, you are investing in your company. That comes with two risks: the risk that the investment could lose value, and the risk that you pay tax on property you might not be able to keep.

But on the other hand, the gains on that stock investment could be taxed at favorable rates for long-term capital gains.

We can mitigate the risk of overpaying tax. The recommendation here is to exercise early when the market value of the ISO is equal to the strike price. When there is no difference between these two amounts, there is no tax cost for performing the early exercise.

Whether an early exercise is right for you is a decision that only you can make. You will need to assess your own financial goals and risk tolerance when making this decision.

Tax Move Takeaways

  • Early exercising is the opportunity to buy stock in your employer’s company before your incentive stock options vest.
  • The main benefit: the earlier you exercise, the greater likelihood the value of the stock is closer to the strike price, which results in less of a bargain element subject to the Alternative Minimum Tax.
  • The main drawback: the risk that your stock investment will lose value.
  • If the fair market value of the stock is equal to the strike price, then consider exercising early and making an 83(b) election. This is results in zero tax cost for an early exercise.
  • Talk to a tax advisor, who can run the numbers and help you figure out the financial impact of your incentive stock options.

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