Early Exercise of Stock Options: A Comprehensive Guide for Employees

What if we told you that you do not need to pay 37% tax on stock-based compensations? That is the power of early exercise of stock options. It can save you from short-term capital gains tax treatment. Furthermore, early exercise of stock options can also lower your exercise price and increase your profits.

In this article, we will discuss how you can make the most of the early exercise of stock options and the processes you must follow to early exercise.

A Compact Employee Stock Options Guide

Before we dive into early exercise, through this employee stock options guide, let us take a quick recap of the definition, purpose, and characteristics of employee stock options.

What are employee stock options?

Employee stock options allow employees to purchase a set number of company shares at a specific price after a certain period.

Companies offer such incentives for two reasons – to motivate employees and preserve cash. When a company offers such incentives, the employees can earn profits when the company grows and its share price increases.

Some features and characteristics that set stock options apart from other types of compensation are:

What is an early exercise of stock options?

When you buy your company’s stocks via your stock options, it is said that you are exercising your stock options. When you exercise your stock options before they are fully vested, it is an early exercise.

Not all companies allow early exercise, but if your company is one of the select few, you should study this option since it can help you save taxes.

Benefits of early exercising stock options for employees

Some of the benefits that you can unlock through the early exercise are:

Long-term capital gains tax treatment

Capital gains are taxed at different rates and it is based on the length of time the asset is held. Typically, the tax rate for short-term capital gains is higher than the tax rate for long-term capital gains. In the USA, the long-term capital gains tax can go up to 20% but short-term capital gains are taxed as ordinary income, the applicable tax rate can be as high as 37%.

So, when you exercise early, you will qualify for long-term capital gains tax treatment sooner.

Alternative minimum tax (AMT) planning

If you receive incentive stock options (ISOs), you will have to calculate the ordinary income tax and the alternative minimum tax (AMT) and pay whichever is higher. Under AMT, the tax owed is calculated on the difference between the exercise price and the fair market value (FMV) of the stock.

So, to minimise your AMT, you must exercise when the difference between the exercise price and the FMV is the lowest. Early exercise lets you do just that.

Higher profits

Profitable companies either grow in size or pay their shareholders. So, if your company is expected to do well over the next few years, its shareholders will either benefit from rising share prices or dividends.

The longer you stay invested in a profitable company, the more benefits you receive. So, if your company’s outlook is great, you must exercise to start your investment period as soon as possible.

Lower exercise prices

With years, your company’s stock price will grow because of your company’s performance and the inflation in overall asset prices. So, when you exercise, you can buy stocks at a lower exercise price.

Example of Early Exercise

Through this example, we will explore the benefits of early exercise by contrasting it against waiting for the stock-based compensation to vest. We will see how early exercise can reduce taxes paid and help you capture more of benefits like dividends.

We will look at John and Lucas, two employees at Dexpharm, an American pharmaceutical startup. They received stock options today which will be vested fully in two years but they can exercise early. Other details of their stock options are as follows.

Suppose John does an early exercise and Lucas doesn’t. Then, John’s stocks will qualify for long-term tax benefits in 1 year but Lucas will have to wait 3 years to get the same benefits.

Since John’s adjusted gross income was $100,000, he did not need to pay the alternative minimum tax (AMT). After 1 year, the company paid a dividend of $0.5 per share.

Let us assume that a total of two years has passed, Lucas has also exercised, the FMV has doubled, and both of them sell off their stocks. To keep things fair, we will assume that both paid the maximum possible tax.

So, we see that John saved $29,750 just through an early exercise of stock options. He also made an after-tax income of $1,000 through dividends. So, his total gains over Lucas were $30,750 ($141,000 – $110,250).

When to exercise stock options as an employee?

To decide whether to early exercise, take the help of the following checklist:

Does your financial condition allow it?

Since you will spend cash to buy stocks by exercising early, you must check if you will need those funds for something more important. If you need the money for things like home loan EMIs, health insurance premiums, or your emergency fund, you should hold off on the early exercise.

Is your company expected to do well?

If you think that your company’s stock price will increase in the future, you should exercise. Otherwise, you may want to wait and see. If you need help to understand whether your company’s stock price will grow or not, allow Eqvista, a trusted valuator, to help.

Given your company’s policies, is early exercise worth it?

You should check your company’s policy for things like:

• Repurchasing terms on termination – These terms describe the conditions for the company to buy back any non-vested but exercised stocks on termination.
• Lock-up periods – You cannot sell your stocks in lock-up periods. A lengthy lock-up period should be a red flag.

How to do early exercise stock options as an employee?

You should take the following steps to early exercise.

Maximise your tax savings with Eqvista!

Stock-based compensations are an excellent way to motivate employees and save cash at the same time. By going for an early exercise of stock options, you can unlock several benefits. You can capture more of the dividends and stock price increases, qualify for long-term capital gains tax benefits sooner, reduce the AMT, and lower the exercise price.

Before you decide to exercise, you should check if you will need the money for other things. You must also have a look at your company’s expected outlook and its stock option policies.

Once you do an early exercise of stock options, you must fill out and submit the 83(b) election form within 30 days.

If you need help deciding whether to exercise, Eqvista’s tax advisory team can help you. We also provide 83(b) election form filing services. Contact us to know more!