Early Exercising Non-Qualified Stock Options (NSOs)
Early exercising Non-Qualified Stock Options (NSOs) can be a fantastic way to save on taxes if you’re expecting your company stock to be worth more in the future. The tricky part is determining whether or not it makes sense for you to early exercise your NSOs.
The purpose of this article is to examine the pros and cons of early exercising NSOs so that you can come up with a good game plan for the equity you have.
We’ll first start by going over how early exercising and NSOs are related, what you need to know about 83(b) elections, and then we’ll dive into the pros and cons of early exercising NSOs.
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Can You Early Exercise NSOs?
The ability to early exercise NSOs is completely up to the company that is granting the NSOs.
Some companies allow it, some companies don’t, and some companies will offer the ability if you ask for it.
Since there’s no single answer, you’ll need to check your specific grant details, company equity plan, and/or ask the compensation team to determine if your company allows employees to early exercise NSOs.
What Does Early Exercising NSOs Even Do?
Having the ability to early exercise means that you do not have to wait until your NSOs have vested to exercise/purchase company shares. If there is no ability to early exercise, you must wait until NSOs have vested before you can exercise anything.
What makes early exercising especially beneficial is that you also have the option to file an 83(b) election with the IRS within 30 days of exercise.
Filing an 83(b) election moves the taxability of your NSOs up to the time of exercise and starts your clock for long-term capital gains. If you don’t file an 83(b) election after early exercise, your NSOs will still assess taxes at the time they vest.
This is why early exercising is usually paired with an 83(b) election. If done properly, it can save thousands to hundreds of thousands of dollars in taxes.
Pros of Early Exercising NSOs
The following list assumes that you both early exercise NSOs AND file an 83(b) election. Without an accompanying 83(b) election, early exercising doesn’t have nearly the same benefits.
Pro #1 - Potential for large tax savings
The single biggest pro of early exercising NSOs and filing an 83(b) election is that if you do it right, it can save you thousands to millions of dollars depending on what ultimately happens with your company shares.
When you early exercise NSOs and file an 83(b) election, it pushes your taxable event up to the time of exercise even though your NSOs are still unvested.
Here’s an example:
Let’s say you received a grant of 40,000 NSOs with an exercise price of $1. In 4 years you decide to sell all 40,000 NSOs at $10/share. The table below shows how dollars will be allocated to ordinary income vs long-term capital gains.
Exercising when the exercise price is close to the current market price, means that future gains can be subject to long-term capital gains rates.
The actual rate of savings between long-term rates and ordinary income can vary based on the person, but the savings can be as high as 17%. (And if that were the case here, you’d have over $60k in tax savings!)
Pro #2 - Allows you to exercise before big spikes in price
The second pro of early exercising NSOs and filing an 83(b) election is that you can exercise before there are large jumps in the share price.
As we illustrated in the earlier example, early exercising before a company’s stock price jumps can save you money someday when it’s time to sell.
What’s nice about the ability to early exercise NSOs is that you don’t necessarily have to do it all at grant or shortly after. If during the vesting period you notice that things are looking up and there’s a real potential that the company stock is going to increase, you can early exercise at this point as well.
The downside to this method is that it can cause taxes to be owed since the difference between the current market value and the exercise price is taxed at exercise.
Pro #3 - Gives you state residency flexibility
Early exercising your NSOs and filing an 83(b) election makes it easier to avoid state income taxes someday if you sell your shares for a gain.
This is a benefit of early exercising that we do not see discussed enough by advisors.
The difference between the market value and the exercise price is known as the bargain element or spread. A portion of tax is attributable to the state/states you’ve lived in based on the value of your NSOs from grant until exercise.
Guess what happens to anything above your bargain element/spread?
The taxable income on anything above your bargain element/spread at exercise is determined by where you live when you sell.
This means that if you early exercise NSOs when the exercise price equals the current market price, you can have some flexibility to plan your state residency to potentially save some money on taxes – especially if you live in a high-income tax state like CA or NY.
Of course, moving solely to save money on taxes might not be the best decision, but if we’re talking about hundreds of thousands of dollars or millions of dollars in savings, then it’s at least worth consideration and a discussion with an advisor.
Pro #4 - Starts the clock for qualified small business stock (QSBS)
This pro doesn’t always come into play, but when it does it’s very valuable. If you sell shares that qualify for a QSBS exemption, you get to exclude up to $10M worth of capital gains (sometimes more with advanced planning).
Early exercising NSOs and filing an 83(b) election starts the clock on QSBS whereas usually you’d need to wait to vest then exercise to start the clock on QSBS.
In order to have a shot at QSBS treatment, you need to hold QSBS-eligible shares for at least 5 years.
If you’re at a company nearing an IPO or an already public company, your QSBS ship sailed long ago. However, if you’re at an early start-up, there’s still a chance that you have potential for QSBS-eligible NSOs/shares.
Cons of Early Exercising NSOs
Now that we’ve covered many of the pros of early exercising NSOs and filing an 83(b) election, we need to address some cons. This article doesn’t cover all the possible cons, so depending on your situation, we still recommend discussing with an advisor you trust.
Con #1 - You still have to pay the exercise price
The first con of early exercising NSOs is that you will still have to come up with the cash to exercise.
Depending on the stage of the company, the exercise price on your NSOs could be pennies or it could be dollars.
40,000 NSOs multiplied by an exercise price of $.01 is no big deal, but if you had an exercise price of $20 then that’s a different story.
Con #2 - Could still owe taxes
If the stock price of the company goes up between grant and the date you early exercise, you will still have taxable income – even if you file an 83(b) election along with your early exercise.
When exercising NSOs, you will have ordinary income based on the bargain element at the time of exercise. The act of early exercising and filing an 83(b) election doesn’t mean you get to postpone taxes you’re supposed to pay.
Con #3 - The company’s stock could never have real value
One of the toughest things with early exercising NSOs is that you have no idea what the company stock is actually going to do in the future.
If you’re at a really early-stage company, early exercising NSOs is like buying lottery tickets. If you’re at a little later-stage start-up, it’s like buying slightly better lottery tickets.
Ideally all start-ups succeed and all mature start-ups increase in value, go public, or are acquired, but that is not the norm.
If you exercise NSOs, you just have to hope that your shares will be worth something someday.
Con #4 - Need to wait until vest to sell still
Even though early exercising means you now have shares, they will still be subject to their vesting conditions. This means that you can’t just turn around and immediately sell your shares if the price goes up. You have to have actually met the vesting requirements before selling your early exercised shares.
Con #5 - If you overpay taxes, you won’t get it back if you forfeit NSOs later
If you quit with NSOs or are laid off with NSOs (LINKs), you will likely forfeit any unvested NSOs back to the company.
So what happens if you owe taxes as part of an early exercise with an 83(b) election? Does the IRS give you the taxes you paid back?
Nope. In fact, you don’t even get to use the loss as any kind of capital loss since you never disposed of shares for a loss.
This is another reason to be very careful with early exercising if you’re going to still owe taxes.
Con #6 - You can’t forget to submit your 83(b) election
You have 30 days from exercise (not grant!) to mail your 83(b) election to the IRS. If you miss this 30-day window, then there’s not much you can do. If you’re at an early stage start-up, there’s a chance they’d be willing to cancel and regrant you NSOs to essentially redo the whole thing, but it’s a major inconvenience and not a good look for you.
Many lawyers and tax advisors recommend sending one copy of the 83(b) to the IRS via certified mail, one to yourself, and one to the company. (Previously, you’d have to attach the 83(b) election to your tax return, but that’s no longer a requirement at the Federal level.)
It’s an extremely important step and one that cannot be forgotten.
Con #7 - Your cash could be locked up for a long time
If you early exercise NSOs you need to be realistic about the potential timelines. If the company is private, you may not be able to sell your shares for years after exercise.
Final Thoughts on Early Exercising NSOs
For some people, it makes sense to early exercise NSOs and for others it does not. Consideration must be taken completely on a case-by-case basis, but if done correctly and things play out in your favor, early exercising NSOs and filing an 83(b) election can be extremely beneficial.
If you need help determining what’s right for you, we’re here to be a resource for you. Please reach out to team@equityftw.com with any questions you have. Thanks for reading!