Many companies offer their employees stock options as part of their compensation packages. Stock options offer the right to purchase shares of the company at a fixed exercise price for a specified number of years. For example, your employer may offer you options to purchase 10,000 shares of the company at a strike price of $1 that vests over four years with the first 25% vesting on your one-year anniversary. Generally, options are exercisable on or after their vesting date. However, some optionees have the opportunity to exercise options before they vest in what is called an early exercise option. This type of compensation may provide the opportunity for a significant payout in the future if the value of the stock continues to rise after the options are exercised. But option exercises also create the potential for a significant tax bill. Some people can reduce their tax liability by exercising stock options early, and we’ll discuss the benefits and risks of this strategy below.
Exercising Stock Options Early: What Are the Advantages?
Exercising stock options creates bargain element. The bargain element is the difference between your exercise price and the Fair Market Value (FMV) of the stock on the day you exercise your options. Typically, when you’re first granted options, the exercise price of the options and the Fair Market Value (FMV) of the stock are the same. Therefore, the bargain element could be lower if you exercise your options soon after receiving the grant. Once you exercise the options and acquire the shares, any future growth in the value of the stock has the potential to be taxed at long-term capital gains tax rates if specific holding period requirements are met. The tax rates that apply to the bargain element are generally higher than the tax rates that apply to long-term capital gains. For this reason, one advantage of exercising stock options early is the potential to reduce the bargain element that is subject to higher tax rates. The second benefit of early exercise is that you can start the clock to meet the holding period requirements to qualify for long-term capital gains tax rates sooner.
Whether or not exercising stock options early is right for you will ultimately depend on the type of stock options you have. This is because the “bargain element” of Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) are taxed differently and the options themselves have different rules regulating them.
Exercising Stock Options Early: ISOs
ISOs can be more tax-friendly than NSOs because you do not need to report the bargain element as income for ordinary income tax purposes in the year that you exercise the options. As a result, their exercise doesn’t automatically create an ordinary income tax liability even if the exercise price is meaningfully lower than the market value of the stock when the option is exercised. However, exercising ISOs could subject you to the Alternative Minimum Tax (AMT) depending on your tax situation. This is because you have to report the bargain element of the ISO exercise as AMT preference income. With proper tax planning, it is possible to determine what amount of ISOs can be exercised in any given year with minimal AMT tax impact to you.
In our prior example, let’s assume that we are exercising ISOs early:
If you exercise the first 2,500 options after your first year of service when the FMV is $2 a share, you won’t have to report the bargain element for ordinary income tax purposes, but you will need to report it for AMT purposes. The bargain element recognized on the transaction when combined with the rest of your tax picture could subject you to AMT. However, you will not be subject to ordinary income taxes or AMT if the FMV of the stock when you exercise the options equals the exercise price.
Exercising Stock Options Early: NSOs
With NSOs (as with ISOs), you will not be subject to ordinary income taxes if the bargain element when you exercise the options is zero. However, unlike ISOs, any positive bargain element from exercising NSOs must always be reported as income on your tax return and the bargain element will be subject to your highest marginal tax rate.
Let’s revisit our example but now imagine that the stock options are NSOs:
If you exercise 2,500 NSOs after your first year of service when the FMV of the stock is $2/share, you will have bargain element totaling $2,500, which will need to be reported as ordinary income on your tax return. Of course, the lower the bargain element the lower the amount of ordinary income you have to report.
An Important Note if You’re Exercising Stock Options Early
If you’re exercising stock options early but fail to make the 83b election within 30 days of doing so, you will lose any tax benefits that come along with early exercise. So, you must be sure that you’re staying on top of this timeline and properly file an 83b election.
Risks of Exercising Stock Options Early
As with most strategies involving investing, there are risks that come along with exercising stock options early:
- Stock Risk: You will be subject to company-specific risks once you exercise your stock options early and take ownership of that stock. The longer you hold the stock before you can sell the shares, the greater the time that you bear the company-specific risks. Moreover, there is no guarantee that the value of the stocks will rise after you exercise your options. If the value of the stock falls after you exercise your options, you may end up with a loss.
- Termination Risk: If, for whatever reason, you’re exercising stock options early but end up leaving that employer before they vest, you run the risk of losing out on money. Most employers – though not all – will buy back your stock at the strike price. However, if you exercised your options at a strike price of $1, and now the market value is $5, your employer is going to buy those stocks from you at $1.
- Capital Risk: When exercising stock options early, you need to pay the cash upfront. This could put you in a liquidity crunch since you’ll have to wait at least until the stocks are vested to get any return from selling the shares. Private company shares have the added risk of not having a ready buyer for the shares when you are looking to sell the stock.
Should You Consider Exercising Stock Options Early?
Ultimately, making decisions about exercising stock options early will come down to a few factors: personal preferences, financial and tax situation, and your desired level of risk. However, you should also think about what types of options you have and the terms that come along with your options agreement.
If you’d like to discuss your stock options strategy with an experienced financial advisor you can trust, we can help. At Wade Financial Advisory, we serve clients with stock option compensation structures, and we can help you walk through the possible outcomes of exercising stock options early to help you determine whether it’s right for you. To learn more, please contact us today.