The early exercise option is more complicated and financially riskier for the employee than either the plain vanilla Incentive Stock Option (ISO) or Nonqualified Stock Option (NSO) plan designs. However, adoption of an early exercise plan will result in substantial tax savings to an employee if his or her employer is quick to meet its financial goals and the employee intends to sell the stock obtained from the exercise relatively shortly thereafter (1 Year). The goal is usually an acquisition, merger or initial public offering (IPO) with an accompanying quick increase in the stock value.

How it Works

In the typical option plan the employee waits at least a year to exercise any options. At the end of that first year he or she can exercise 25% and then another 25% each year for three more years. In contrast, the early exercise program allows the options to be exercised immediately after grant, rather than waiting for any vesting period.

However, the stock issued is called restricted stock because it comes with stipulations. The restrictions are usually set forth in a stockholders agreement that is referenced on the face of the stock certificate. The restrictions include a requirement that the employee must sell the stock back to the employer at the original purchase price if employment terminates before a specified time, the vesting period.

In addition, the employee is not permitted to sell or transfer the stock during the restrictive period. In other words, the stock is subject to a vesting schedule similar to what would normally be incorporated in a typical stock option plan. For example, the restrictions could lapse 25% a year or upon the company meeting certain financial objectives. Once the restrictions lapse, the employee has full ownership rights in the stock.

Example: Company X issues an NSO to purchase 25,000 restricted shares at $2 per share. The restrictions provide that under normal circumstances 25% of the shares will become vested each year as long as the employee is still with Company X. The restrictions also provide that if Company X is acquired all shares become fully vested. The employee believes the stock price will reach $25 per share in four years or the company will be acquired before the four-year period ends. If the employee exercises the option immediately there are no tax implications. This is because the general rule of Section 83 of the Internal Revenue Code provides that if an employee receives stock with a substantial risk of forfeiture there is no income until the risk is lifted, but there is taxable income recognized at that time.

The employee naturally wants to make certain that the Internal Revenue Service (IRS) does not apply this general rule of Section 83. Rather, the employee wants the transaction to be considered a taxable event under the provisions of Section 83(b) knowing that the amount of taxable income is $0. This is because the fair market value on the date of exercise is equal to the purchase price of $2.

The Section 83(b) Election

If the IRS were to apply the Section 83 general rule and defer the initial tax event until the stock restrictions lapse, when the stock is more valuable, the taxable income required to be recognized is the difference between the fair market value of the stock and the price originally paid ($2) on each date that the restrictions lapse. The gain is taxed as if it were compensation income using the ordinary tax rate schedules.

To prevent this, the employee is advised to make a Section 83(b) election. This election, which must be made within 30 days of receipt of the restricted stock, allows the employee to ignore the fact that the stock is restricted when received and requires the IRS to treat it likewise.

Suppose that the employee in the first example waits a few months after the grant of the options and exercises the options when the stock is valued at $3 per share. Company X is acquired in year 3 and the employee sells all the shares obtained from the option grant at $25 per share.

$25,000 ([$3-$2] x 25,000) of taxable income is recognized at the time of exercise and a capital gain of $550,000 ([$25-$3] x 25,000) is recognized at the time of sale. The $550,000 profit would be long-term capital gain because the one year holding period has been met.

The federal long-term capital gains rate for individuals is currently capped at 20%. Company X gets a tax deduction for the $25,000 reported as ordinary or compensation income by the employee at the time of exercise. The risk in making the Section 83(b) election is that if the stock falls in value after the option exercise there is no tax refund allowed for the tax already paid.

The Standard NSO Plan

To contrast the examples above with a standard NSO plan, with a four year vesting and the acquisition acceleration provision, what would probably happen is something like the following:

The employee probably would not exercise the options until he or she was about to sell. If the employee exercised at the end of the first year on the 25% of the options that were vested, he or she would have to pay tax on the gain at ordinary rates.

So why exercise unless a sale decision had been made for that portion of the option? The employee at that point would rationally reason that there is no sense in taking risk and putting out money until the time for sale has arrived. Why purchase early when you can buy for $2 a share at any time during the exercise period?

The employee would probably exercise the option to purchase the stock after the acquisition had been completed and when the fair market value is at $25 per share. The ordinary income recognized for tax purposes is $575,000 [($25-$2) x 25,000]. If the stock is then sold immediately after exercise there is no capital gain because the sales price ($25) is equal to the employee's basis. Since the federal ordinary income rates can be as high as 39.6%, the tax on this transaction could be almost double that of the early exercise examples.

Early Exercise Benefits

As a general rule, employees in start-up companies on the IPO tract have the potential to benefit significantly from this early exercise arrangement. This is because they can exercise the options while the stock is at a low price and before the company becomes publicly traded.

Employees in mature, "old economy" companies, not likely to take a quick jump in value normally would not be interested in this type of plan. These employees would be better off just buying the stock on the open market, without any restrictions, if they wanted to invest right away and then hold the stock. Employees in this type of organization generally prefer the more typical stock option plans.

Employees in an early exercise program could choose to wait until the stock restrictions lapse and the sale decision has been made to exercise the options. They would then be in the same position as they would have been under a non-early exercise plan. However, the early exercise plan gives employees the ability to exercise when the stock price is low and then have all or most of the gain taxed at the more favorable long-term capital gains rates.

An early exercise plan normally contemplates the issuance of NSOs but can also be structured with an ISO. It is not usually done this way and therefore this article only relates to issuing NSOs.