Many companies that offer stock options as part of their compensation packages allow employees to exercise those options before they vest. This practice is known as early exercise, and many employees in pre-IPO companies have successfully used it to avoid hefty tax bills. Exercising stock options early can be risky, so it’s important to understand what you could lose as well as what you stand to gain. Here are five tips for deciding whether and when to early exercise your company-awarded stock options.
1. Don't bet more than you can lose.
This is always an important rule to follow. Early exercise means buying stock in a company before it reaches IPO. This involves some inherent risk, and it also means that you may not be able to sell your shares for quite some time. Make sure that any purchase of company stock makes sense within your overall financial plan.
2. Make sure you understand the immediate consequences.
Exercising your stock options without understanding the tax implications could leave you with a shocking tax bill. Here are some basic principles to understand:
Income Tax and the AMT
The paper gain (or bargain element) of an incentive stock option (ISO) is the difference between the price paid and the fair market value. This is not included in regular income tax when options are exercised, but it is included in the alternative minimum tax (AMT) calculation. It’s important to work with a tax professional when exercising stock options to understand whether and to what degree you may be subject to the AMT.
An 83(b) election makes the shares that you purchase through early exercise taxable at the time of granting rather than at the time of vesting. This can be beneficial because shares are typically worth much less earlier in the IPO process, when the future of the company is less certain. By reporting the paper gain when it’s small, you incur a smaller tax bill.
On the other hand, if the company isn’t as successful as you hope, you may end up paying taxes on gains that may be difficult to realize. If the value of your shares declines, you won’t be able to recoup the taxes you’ve already paid on them.
3. If you make an 83(b) election, make sure it's done right.
After you early exercise stock options, you have 30 days in which to make an 83(b) election. If the stock’s value has risen significantly during this time, failing to make a timely 83(b) filing can be costly. After informing the IRS of your election, you’ll need to send a letter to your employer to notify them as well. In some places, state or local tax jurisdictions must also receive notification of an 83(b) election.
4. Be aware of holding periods.
Making an 83(b) election starts the clock on important holding periods that must elapse before you can enjoy certain tax benefits. If you don’t make an 83(b) election, then the clock starts when you actually receive the stock. To qualify for long-term capital gains treatment, you must hold the stock for at least one year before selling it. Otherwise, the gain is treated as ordinary income. If you hold qualified small business stock (QSBS) for at least five years, then gains on the sale could be exempt from federal taxes. Work with a tax professional to make sure you’re getting the best possible tax treatment of your gains.
5. Be aware of lockout periods and trading windows.
Even after your company reaches IPO, you probably won’t be able to sell your shares right away. Typically, employees are barred from selling shares of company-awarded stock within six months of IPO in order to protect the stock value. After the lockout period, you may still be subject to trading windows that limit when you are able to sell. Establishing a 10b5-1 plan while you are not privy to insider information that’s not publicly available can allow you to sell shares on a predetermined schedule, however.
Whether and when you choose to exercise your stock options—and how you handle the tax consequences—can have a huge impact on your financial future. Working with a trusted financial advisor who understands the IPO process and the tax implications that surround it will give you the insight you need to make sound decisions at this critical time. For more information about stock options and how to make the most of them, follow the WRP blog.