What are the main benefits of early exercising stock options?

Early exercise lets employees cash in their stock options before their vesting date, provided their employer approves it.

But why should you exercise stock options? It indeed helps you save a lot on taxes. However, there are more key reasons to consider early exercising stock options.

If the stock’s value keeps going up once the options are exercised, this form of compensation could lead to a substantial payout. Just not this, there’s more – we’ve added more insights about the benefits of early exercising stock options and some valuable resources to optimize your tax planning.

Main Benefits of Early Exercising Stock Options

If the company’s stock price will rise substantially, letting employees exercise their options early can be a huge benefit. There are other significant benefits of early exercising stock options.

Tax Advantages

One of the most important benefits of early exercising stock options is the tax advantage. ISOs (Incentive Stock Options) can be more tax-friendly than NSOs (Non-Qualified Stock Options).

#Case 1 – ISO

When exercising ISOs, the bargain element (the difference between the exercise price and stock market value) does not have to be included in the income of a taxable year, which is relevant for regular taxation. This implies that exercising ISOs will not incur income tax liability unless the stock value exercise price exceeds the market rate.

Nevertheless, this practice may also have adverse tax consequences, such as triggering AMT. This is because the bargain element is characterized as AMT income, and, e.g., with deferred compensation, a plan distributes a maximum amount every year. Therefore, you can plan ahead in the year and decide how many ISOs to exercise to reduce the AMT effects.

As an example, if you exercise 2,500 ISO options at a time when the FMV of the stock is $2 per share, and the exercise price is $1, you won’t report this time because it is for ordinary income taxation. However, in this case, you must declare it for AMT purposes. So, if you exercise it when the FMV is equal to the exercise price, there is no income tax exposure or AMT.

#Case 2 – NSO

With non-qualified stock options (NSOs), there is no tax if you do not exercise it when without a bargain element. However, if this element exists, it is no longer called a tax-free return, as you would need to report it as an income. It will be taxed under your highest tax bracket.

For example, when you exercise 2,500 NSOs when the stock’s FMV is $2, and your exercise price is $1, you’d have $2,500 of the bargain element to be reported as income.

Note – If you decide to exercise your options early, you must file 83(b) within 30 days of exercising to enjoy the tax benefits within the law. This lets you pay taxes on the current value of the stock to limit loss benefits in the event growth in the stock price occurs. This is critical – if you do not follow this, you stand to forfeit tax relief on the early exercise of options.

Maximizing Financial Gains

Let us discuss the benefits of early exercising a share option.

• Lower price – If you exercise your option early, you can buy shares at a lower cost than if you choose to wait. This advantage applies to fast-expanding enterprises whose share value rises quickly as well.
• Higher potential gain – An early exercise could yield greater profits if the stock price of the oriented company increases in the future. With this, you have established a lower cost base for your stock.
• Extended holding period – If you exercise your option early, the holding period will begin earlier, and consequently, you will be eligible for taxation on long-term capital earnings after a very short period.

Reduced Risk of Stock Price Increase

By early exercising your stock options, you could address the risk of an increase in future stock prices in several ways.

• Locking in current price – Early exercising means that you purchase shares at the current day’s price. This also prevents you from paying more later during further price elevations.
• Avoid higher costs – If the company matures and its worth appreciates, waiting to exercise the options may be unbearably expensive. Early exercise avoids this problem.
• Benefitting from trends – It is common for the stock of many successful startup stocks to appreciate over time. Thus early exercising helps you benefit from such trends in stock values.

For example, you can acquire 1,000 stocks at $1 each. If you wait till the stock price rises to $10, and you want to exercise, it would mean paying $10,000. But if you exercised earlier and paid $1, you’d have only paid $1,000.

Alignment with Company Growth

Early exercising of stock options is one way to establish alignment between employees and the organization’s goal. Employees who hold actual shares rather than options feel further connected to the corporation.

Thus, a sense of financial ownership can increase the level of effort and work loyalty. Since their financial growth is at stake, employees will be more committed and ensure cross-sectional strategies that enhance the firm’s profitability.

Note – Not everyone has the same advantages of exercising early. That depends on one’s readiness to take on risks and present financial status. In most cases, companies that permit early exercise of the option provide education and encourage people to make decisions.

Mitigating Alternative Minimum Tax (AMT) for ISOs

There’s a chance that you could become liable to Alternative Minimum Tax (AMT).

A larger bargain element means a bigger AMT bill. Some people avoid exercising ISOs because of this tax, but that’s not always the best strategy. if you wait to exercise, you might be subject to a higher AMT when the stock price increases.

Here’s an example:

If you exercise and hold shares from 8000 ISOs with a grant price of $2 and a current market price of $40, your bargain element would be:

Bargain element / AMT Income = (Market Price – Grant Price) X Number of Shares

($40 – $2) x 8,000 = $304,000

Assuming an AMT exemption of $85,700,

Taxable AMT income = AMT Income ($304,000) – AMT Exemption ($85,700) = $218,300

Assuming a flat 26% AMT, you will owe:

AMT = Taxable AMT income x Tax Rate
$218,300 x 26% = $56,758

The amount of AMT you owe will be $56,758 when you file your tax return in April of the following year. Given this staggering figure, it’s easy to understand why many people choose not to exercise: the tax implications would be too much to bear.

As a result, it could be beneficial to start exercising at the beginning of the calendar year.

Why should you choose Eqvista’s Tax and Equity Advisory Services?

Eqvista’s Tax and Equity Advisory Services help founders, employees, and investors manage their equity and taxes effectively. Here’s why you might consider choosing Eqvista:

• Comprehensive Tax Planning – Eqvista’s qualified tax professionals deal with concerns such as Qualified Small Business Stock (QSBS) and early exercise, and issues pertaining to stock options such as vesting. We explain to you applicable tax aspects of equity types, such as RSUs, RSAs, ISOs, NSOs, and phantom stock options. We help you understand AMT tax management and identify short-term and long term developments.
• Equity Management Solutions – At Eqvista, our all-in-one platform for financial management offers cap table management, valuation services, 409A compliance, and simplified IRS filings. This systematic way makes sure no mismatches happen between your equity management and your records.
• Personalized Advisory Services – Eqvista takes a customized approach to each client. Before making any changes we always conduct the assessment of the client’s existing situation in terms of tax and equity. Post-analysis, we offer a strategy to improve the financial status.

More than 15,000 organizations have succeeded with Eqvista’s services in simplifying equity-related operations and managing tax complications. Through Eqvista’s equity tax planning, they’ve saved an average of $5,000+.

Frequently Asked Questions (FAQs)

What is an early exercise of stock options?

If your employer permits early exercise of stock options, you can cash in on your shares before they officially vest. Only a few businesses allow employees to exercise their equity early to promote future tax savings.

How does the 83(b) election work?

The IRS 83(b) Election, if applicable, should be filed within 30 days from the date of the early exercise. This determines your purchase date and taxable value of the asset. That way, you can ensure that your exercise remains tax-efficient and that your asset will hopefully qualify for capital gains treatment in the future.

What are the risks of early exercising stock options?

As with any investing technique, exercising stock options before their expiration date has potential downsides. The exercise of stock options does not necessarily imply an increase in stock value. After exercising your options, you can incur a loss if the stock price drops.

How can I determine if early exercise is right for me?

Decisions regarding early stock option exercise are ultimately up to individual choices, tax and financial circumstances, and risk tolerance. However, you should also consider the terms of your options agreement and the options available to you. The best way to determine if early exercise is right is to consult a tax expert.

Get Expert Consultation From Eqvista!

Early exercising stock options can be smart, but it’s not always simple. You might save on taxes, make more money if the company does well, and feel more connected to your company’s success. Plus, you can lock in a lower stock price and avoid some tricky tax situations.

However, it can get complicated fast. That’s where Eqvista’s Tax Advisory and Equity Consultation Services become helpful and maximize the benefits of early exercising stock options. Our team of accredited advisors can help you develop a personalized strategy for early exercise, considering your financial situation and goals.

We can guide you through complex processes like 83(b) elections and help you understand the tax implications of your decisions. Contact Eqvista today for a consultation and start making informed decisions about your stock options.