What are early-exercise stock options that are immediately exercisable but for shares that must still vest and have a company repurchase right?
Some companies grant stock options that are immediately exercisable, but you receive shares that still need to vest before you own them outright. Until then, the stock is still subject to a repurchase right if your employment ends before vesting. Check your grant agreement for whether your options are immediately exercisable at grant before vesting, and check the repurchase details. At some companies this is called a restricted stock purchase plan or early-exercise stock options.
Advantages And Disadvantages
Early-exercise options let employees who wish to make an early investment decision about the company start their capital gains holding period sooner. If you hold the stock, not just the options, for at least 12 months, you will pay lower taxes on the later sale. For qualified small business stock held more than five years, a special 0% rate applies.
In a private company, the downside is that the shares have no liquidity (i.e. are not tradable even when vested). Your funds are tied up in the payment of the exercise price (unless a loan is involved). You may be holding the shares for an indefinite period until any IPO or acquisition or until the shares become worthless.
When the spread is zero or negligible, early exercise also minimizes the chance of any alternative minimum tax on ISOs, and ordinary income for NQSOs on the spread at exercise. The plan and grant agreement/notice must allow you to exercise your options immediately into stock. Usually, the company can buy the stock back at your exercise price (or another price your plan specifies) if you leave within the original vesting period.
What Happens At Early Exercise
At exercise, you have essentially purchased restricted stock with the same vesting schedule that applied to the stock options. These shares once they vest are restricted securities and cannot be immediately resold under the securities laws. (For more on the difference between restricted stock and securities, see a related FAQ.) You should make a Section 83(b) election and file it within 30 days of exercise with the Internal Revenue Service.
Alert: In this situation, you make a Section 83(b) election even when you have paid the fair market value for the restricted stock and there is no discount or spread. You report that you have zero income for the value of the property received. Otherwise, you will owe ordinary income later on the stock's appreciation in value between purchase and vesting (see the case Alves v. IRS Commissioner, decided in 1984).
Tax Treatment For Early Exercise
The election essentially says that you agree to recognize as ordinary income for NQSOs, and as an AMT item for ISOs, any spread between the stock's fair market value and your exercise price. In this way, the future appreciation on the NQSO stock can be taxed at favorable long-term capital gains rates at the sale of the underlying stock. Without the timely Section 83(b) filing at exercise, you recognize the income on the spread at vesting for both ISOs and NQSOs.
Alert: Should you forfeit the unvested shares, you cannot claim a tax loss for the amount of compensation income you paid tax on for your exercise.
As explained in another FAQ and article, ISO taxation is more complex for early-exercise options with an 83(b) election. For example, in a sale before the ISO holding periods are met (i.e. disqualifying disposition in a sale within two years from grant), the ordinary income is the lower of either the spread at vesting (remainder is capital gain) or the actual sale gain.
Status Of Your Shares After Exercise
The period for the company's repurchase right is similar to the cliff or graduated vesting schedules for traditional stock options. In exchange for the potentially lower tax on sale of the stock, you do commit money to your company's stock earlier. Although the unvested shares you receive upon purchase/exercise may be held in an escrow account until they vest, they are outstanding shares that confer voting rights and eligibility for dividends. Occasionally, when permitted by law, companies offer loans to employees to encourage this early exercise.
Alert: You do not need to make this filing for standard stock options that you can exercise only after vesting. The stock you receive at the exercise of vested stock options is not subject to a substantial risk of forfeiture that triggers the ability and need to make a Section 83(b) election.
For additional details on these types of stock options, see the related articles elsewhere on this website.