An early exercisable stock option allows the employee to buy company stock before it fully vests. A private company or start-up may make this option available to its employees as part of a benefit package.
In most stock plans, the employee receives common stock that is vested over time. Exercising their stock option is not possible until the vesting period has elapsed. If the stock plan allows for early exercises, employees can exercise before their stock fully vests. This can be a huge benefit if the stock continues to increase in value. However, it is essential to know the potential tax implications of exercising a stock option early.
What is a stock option?
A stock option is a benefit that an employer can give to an employee as part of an incentive package. Giving an employee a stock option allows them to purchase a particular stock at an agreed-upon price within a specified time. The employee receives the option to purchase the stock, but they are not required to do so.
Stock options can be statutory or nonstatutory.
- Statutory stock options are granted under an employee stock purchase or incentive stock option (ISO) plan. Exercising an ISO does not generate immediate income or the need to pay regular income taxes as long as you hold the stock for at least a year. Income is reported when the stock is sold. However, exercising an ISO does require an adjustment for the alternative minimum tax.
- Nonstatutory stock options are not granted under a plan. They are also called non-qualified stock options. Income taxes are due when the stock is purchased. Taxes are based on the difference between the amount paid for the stock and the fair market value.
What does it mean to exercise a stock option?
Exercising a stock option means buying the stock according to the contractual agreement. If an employee receives the option to buy stock as part of their benefits package, the contract will stipulate the number of shares available, the purchase price, and the time frame for the purchase.
The timeframe during which the employee can buy the stock is called the vesting schedule. The employee must wait for the stock to vest before they can purchase the shares at the agreed-upon price. By having a vesting schedule, the employee can discourage new employees from buying stock in the company and then leaving or reselling the stock. It helps ensure that employees are committed to the company’s success over time. The option expiration date is the date by which the employee must exercise their stock option, or they will lose it.
Timing can be very important. For example, if an employee is offered 50 shares of common stock with a grant or strike price of $50.00 per share and the current price per share for the stock is $70.00, If the employee can exercise their option, they can purchase stock at $20.00, below the current price per share. They may decide to sell the shares to make an immediate profit of $20.00 per share (less any taxes or fees). However, an employee can only sell shares that are fully vested.
What is an early exercisable stock option?
If the employee is permitted to buy the stock before it has fully vested, it is an early exercisable stock option. The stock will continue to vest according to the contractual schedule. Any stock that is not vested is restricted stock. If the employee leaves the company, the company has the right to repurchase any restricted stock.
Why would an employee exercise their stock options early?
Reasons an employee might exercise their stock options early include the following:
- Avoid missing the expiration date: Many employees neglect to exercise their stock options, resulting in the option being forfeited. Exercising stock options early can prevent this.
- Tax advantages: If stock options are non-qualified stock options (NSO) and are exercised early, their tax burden should be low, especially if the stock price hasn’t changed significantly. The employee should also file their 83(b) election within 30 days of the purchase and lock in the current value of their stock for tax purposes. The employee will claim the spread or difference between the price the employee paid for the stock and its fair market value as ordinary income. Purchasing stock earlier and holding it for at least a year may also allow the employee to qualify for long-term capital gains treatment earlier. The employee will be liable for all applicable income taxes when the 83(b) election is made. If they leave the company and the company buys back the restricted stock, the employee will not get a refund on their taxes. If the 83(b) election is not made in a timely manner, the employee will be taxed on the spread between the stock value on each vesting date and its purchase price.
- Investment advantages: The employee may want to exercise their stock options early if the strike price is lower than the current price per share and the employee believes the value of the stock will increase.
- Shareholder advantages: the employee owns stock earlier and, therefore, may get shareholder privileges, such as voting rights earlier.
Why would an employee not exercise their stock options early?
If the employee is unsure about the financial security of the company, they can lock in their stock options at the exercise price and wait to see whether the stock increases in value over time. This can be a good option if a new employee does not want to risk losing all or part of their investment in the company’s stock if the company’s stock price were to decline.
The tax implications differ depending on whether the stock is an incentive stock option (ISO) or a non-qualified stock option. Options will also vary if a company is acquired. Talk with your financial advisor before exercising your stock options early to discuss the potential risks and benefits.
There is no one-size-fits-all guide to investment. Working with a wealth manager who uses a fee-only financial planning structure can ensure you make the best financial decisions for yourself and your loved ones. Ready to secure your financial future? Call us today at 866-395-1786 to get started.
