Early Exercise Options and Filing an 83(b) Election

An early exercise of stock options allows an individual to purchase shares from their employer before they have fully vested. This is only possible if the company’s stock plan permits it. The original vesting schedule does not change, meaning an employee must still fulfill the service requirements to gain full ownership of the shares.

Paired with an early exercise is an 83(b) election, a formal notification sent to the Internal Revenue Service (IRS) under Section 83(b) of the Internal Revenue Code. This election informs the IRS of the decision to pay taxes on the equity’s value at the time of exercise rather than when the shares vest. This can reduce future tax liability by addressing the tax event when the stock’s value is at its lowest.

Understanding the Tax Implications

Without an 83(b) election, the tax event is deferred until the shares vest. At each vesting date, the difference between the Fair Market Value (FMV) of the stock and the price paid to exercise the option, known as the spread, is taxed as ordinary income. If the company’s value increases over the vesting period, this can result in a substantial tax bill.

Filing an 83(b) election accelerates this tax event to the date of the early exercise. The taxable amount is the spread between the FMV at that moment and the exercise price. For many early-stage companies, the exercise price is set to the FMV at the time of grant, meaning this spread is often zero or very small, resulting in minimal or no immediate ordinary income tax.

Once the election is made, all subsequent appreciation in the stock’s value is treated as a capital gain. The holding period for determining long-term capital gains, which are taxed at lower rates than ordinary income, begins on the date of exercise. To qualify for these lower rates, the stock must be held for more than one year after exercising.

Exercising Incentive Stock Options (ISOs) can introduce complexities related to the Alternative Minimum Tax (AMT). The spread at an ISO exercise, while not counted for regular tax, is an adjustment item for AMT purposes. An early exercise and 83(b) election can help manage this, as the spread is often minimal at this early stage, reducing or eliminating the potential for triggering the AMT. Without the election, the spread at each vesting date would be included in the AMT calculation, potentially creating a larger tax liability.

The election is also beneficial for shares that could qualify as Qualified Small Business Stock (QSBS). This provision allows for a substantial exclusion of capital gains from federal tax if the stock is held for more than five years. Filing an 83(b) election starts this five-year holding period at the date of exercise, increasing the likelihood of meeting the requirement before a sale.

Information and Decisions for an 83(b) Election

First, confirm that the company’s stock plan allows for the early exercise of unvested options, as this is not a universal provision. Following this confirmation, you must consider the financial risk, as the money spent to exercise the options and pay any resulting taxes is non-refundable if the shares are later forfeited.

To complete the election, you must gather specific information. The IRS accepts a letter with all required details, but it also provides the optional Form 15620. Whether using the form or a letter, it must contain the following elements:

• Your full name, current address, and Social Security Number (SSN) or Taxpayer Identification Number (TIN).
• The tax year for which the election is being made.
• A description of the property, including the number of shares and the class of stock.
• The date the options were exercised and the property was transferred.
• A description of the restrictions on the stock, such as the vesting schedule and the company’s right to repurchase unvested shares.
• The Fair Market Value (FMV) of the stock per share at the time of transfer and the total amount paid for the property.

The document must clearly state that it is an election being made under the Internal Revenue Code and affirm that a copy has been provided to the employer.

Step-by-Step Filing Process

The filing process for an 83(b) election is governed by a strict deadline. The election must be postmarked and mailed to the IRS within 30 days of the stock transfer date, which is the date of exercise. This 30-day period includes weekends and holidays, and the IRS does not grant extensions for any reason. Missing this deadline renders the election invalid, and the tax treatment will revert to being taxed at vesting.

After preparing and signing the election, make several copies for distribution and record-keeping. The original signed election is for the IRS. It is best to use USPS Certified Mail with a return receipt requested, as this service provides a postmarked receipt as evidence of the mailing date. The election should be sent to the IRS service center where you file your annual tax return; verify the current mailing address on the IRS website before sending.

One copy must be provided to the company that issued the stock. This ensures the company is aware of the election and can handle its payroll and tax reporting obligations correctly. Another copy should be attached to your personal federal income tax return for the year in which the election was made. Some states may also require a copy of the election to be filed with the state income tax return, so it is prudent to verify local requirements.

A final copy, along with proof of mailing, should be retained for your personal records indefinitely. These documents serve as definitive proof that the election was filed correctly and on time, which can be valuable in the event of any future inquiries or audits from the IRS.

Post-Election and Forfeiture Scenarios

The primary risk after filing an 83(b) election is the potential forfeiture of unvested shares. The election accelerates the tax event but not the vesting schedule. If an employee leaves the company, either voluntarily or involuntarily, before their shares are fully vested, the company has the right to repurchase the unvested shares. This repurchase is usually at the original exercise price paid by the employee.

The most significant financial consequence of forfeiture is that there is no refund for any taxes paid as a result of the election. If you paid ordinary income tax on the spread between the FMV and the exercise price when the election was made, that tax payment cannot be recovered from the IRS upon forfeiture. This rule underscores the main gamble of the strategy: the employee is betting they will remain with the company long enough for the shares to vest.

In a forfeiture scenario, the employee is not left entirely without tax recourse, though it is limited. The amount paid out-of-pocket for the shares that were ultimately forfeited can be claimed as a capital loss. This capital loss, however, is subject to limitations on how much can be deducted each year. The utility of a capital loss is less favorable than avoiding the initial ordinary income tax, making the forfeiture a financially difficult outcome.