83(b) Election for Non Qualified Stock Options (NSO)
83b elections could be handy for people who receive non qualified stock options from their employer.
If you possess non qualified stock options, there is a high chance that you spent some time doing research about how and when you will need to pay their taxes. Generally, NSO recipients are subject to regular income taxes on profits they gain after they exercise their NSOs.
Are you new to non qualified stock options taxation? If yes, this piece will discuss NSO taxation and the 83b election on NSO along with other important details.
Early Exercisable Stock Option
In order to understand what an early exercisable stock option really is, it is important to understand the meaning of the term “early exercise”. Well, early exercise simply means that the option holder gets the common stock subject to the vesting schedule applied for the stock option. In case the option recipient departs the organization before their stock vests, the company usually gets the right to rebuy those unvested stocks.
What is an Early Exercisable Stock Option?
Early exercisable stock options are quite similar to other types of options offered by employers to directors, advisors, consultants, and most importantly, employees. The main thing that makes early exercisable stock options different from other options is that you have to exercise it before it fully vests.
Regardless of this specific requirement, an early exercisable stock option allows the holder to exercise a portion or the entire option right away. However, before you exercise your options early, getting the approval of your organization’s board of directions is a must.
Option holders often decide to exercise their options early for the following reasons:
- If the option holders become stock holders themselves
- Exercising the stock option as soon as the grant date comes up ensures that option holders don’t have to pay hefty taxes when exercising
Many people tend to confuse early exercisable stock options for other things. Let us take a closer look at what some advantages of this are:
What are Some Advantages of Early Exercising of Options?
83b elections used to be a niche problem in the earlier days, which mostly applied to company founders. Unlike most workers, founders get their issue of shares for a cent’s fraction instead of options. Most times, when founding teams acquire venture capital, the terms and regulations of that investment contain a requirement for company founders to exercise their shares in a period of 4 years or more.
While it may seem strange that the people who found or own a company would agree to vesting schedules, investors need it for giving founders an incentive to stay around, sticking through the venture capital investment’s terms. Founders who knew what they were doing, would often file 83b election prior to raising money (before the equity’s appreciation) to begin the clock for long term capital gains qualification. This would also ensure they did not have to pay taxes until their stock sold.
The opportunity to exercise your option early on lets you change the profits on every option, whether it is from long term capital gain or ordinary income, which is taxed at significantly lower rates. There has been a monumental increase in competition when it comes to outstanding employees. The past decade, in particular, saw an increase of high level talent, prompting more companies to offer stock options.
Most stock options issued by tech startups have a vesting period of four years, with a 1 year cliff, and the rest vesting on a monthly basis with 25% gained each year. This vesting schedule would look something like:
|Total Vested Shares
|Year 1, Month 1
|Year 1, Month 2
|Year 1, Month 3
|Year 1, Month 4
|Year 1, Month 5
|Year 1, Month 6
|Year 1, Month 7
|Year 1, Month 8
|Year 1, Month 9
|Year 1, Month 10
|Year 1, Month 11
|Year 1, Month 12
Early exercise lets recipients exercise their stock option before their stock vests. Because of this, it is possible for several workers to buy a part or even their entire stock prior to their specific vesting dates.
If someone earns their shares with the help of vesting by staying with their organization, the IRS treats it as taxable income. This taxable income for NSOs comes when the option holder exercises them into shares.
83b elections have been the talk of the town for a while, especially among the recipients of employee stock options. Below, we will discuss what an 83b election is and its various benefits.
What is an 83(b) Election?
Section 83 b elections are short documents (usually of one page) that recipients have to send to the IRS to notify them about their wish to get taxed early, instead of when its vesting period ends.
Section 83 elections enable companies, especially startups that get restricted stocks, for saving a massive amount of tax, as it’s based on the property’s fair market value when granted instead of the fair market value of the vesting date.
Once you file the 83b election inside a 30 day period, it becomes easier to prevent future tax problems because the forfeiture risk goes away. Not being able to file the 83b election on time can be quite problematic and have unfavorable short and long term consequences for startups.
83(b) Election for Non Qualified Stock Option (NSO) and its Benefits
If you are planning to file for the 83b election, you must make sure whether or not you can opt for it. It would be best to check your employer’s plan document to find out if you can use it. If yes, an NSO 83 b election lets you pay and exercise your pre-vested non qualified stock option’s tax.
Whenever you decide your NSO, the tax you will have to pay will be based on the non qualified stock option’s exercise price and the exercise price at the time. Since these are pre-vested shares, there is a huge chance that there is a smaller spread between these figures compared to how it will become later. The main goal of utilizing 83b elections is converting the potential future price of the appreciation into long term capital gains.
That said, you must discuss your particular scenario with an expert or your accountant for evaluating the price tax rates under every condition in order to find out if the 83b election would benefit you. In the meantime, however, you can get a better idea about whether the election is worth considering by understanding how NSO taxation works.
Impact on NSO Taxation with 83(b) election
Since probable tax liability related to exercising a non qualified stock option is based on a stock’s appreciation, wondering how you could minimize your pending tax bill is not uncommon. This is why more and more people are showing interest in NSO 83 b elections.
As mentioned earlier, non qualified stock options are usually taxable on the same year you decide to exercise them. What this means is that during the period between when the company grants the shares, when you vest them, and before you exercise them, you will not have to pay any taxes. However once an NSO holder decides to exercise these, they pay tax on the gain from the FMV at exercise and the exercise price.
Let’s take an example to see how electing the 83b election on non qualified stock options work:
Say a founder in a company is awarded 20,000 NSOs subject to a vesting period of 3 years. The exercise price of these options are currently $0.50, with a FMV stock price of $0.80 at the time. After the 3 years, the company’s stock price rises to $1.50 and the founder decides to exercise his shares and sell the shares back to the company. The total taxes would look like:
|Taxable gain on 20,000 NSOs
|Income tax (25%)
|Total Gain ($20,000-$5,000)
So after exercising the options, selling the shares, and paying tax, the total gain left is $15,000.
However let’s say that the founder anticipates that the company’s value will increase over the next 4 years, and thus the stock price will rise, so chooses to elect the 83b election on the NSOs.
Here is how the NSO tax would look like:
|Taxable gain on 20,000 NSOs
|Income Tax (25%)
Thus at the end of the vesting period, the founder would only have to pay tax of $1,500. Then later on when he sells the shares at $1.50.
|Original “cost” of shares
|Taxable gain ($30,000-$16,000)
|Capital Gains Tax (15%)
|Total Gain ($20,000-$1,500-$2,100)
You can see in this example that the total tax saving for the option holder is $1,400. This may not seem like a lot from this basic example, but this represents a 28% total drop in taxes compared to no 83b election taken. This is the reason why some founders consider taking a 83b election on their stock options.
When Should You File 83(b) Election?
Stock options are valuable exactly because they are at their core, an option. Knowing you have a long period to decide if and when you will buy your company’s stock for fixed rates is quite valuable. It is a major reason why stock options that are publicly traded have higher value. It is also worth keeping in mind that stock options eventually lose their value once you exercise them, and once that happens, you lose the flexibility these options provide you.
Due to this, a lot of individuals wonder whether they could exercise their option early. If you are one of these individuals too, remember that there are only a couple of scenarios where exercising your options early makes sense.
- It could either be during the initial days of your tenure if you are among the first few employees of your organization
- You could also try exercising your option early if you have a lot of confidence in your company’s success. However, you would need to risk your savings for this
Possible Risks of 83(b) Election
While 83 b elections are great and can yield massive rewards if you utilize them properly, they do not offer guaranteed results. Of course, everybody wants to pay less taxes, but taking advantage of the elections for it has several risks associated with it.
- Unearned shares: When someone uses 83b elections to exercise early, they purchase unvested shares, which they don’t have the rights to or own currently. You must fulfil a particular vesting schedule along with a set of requirements to acquire those rights.
- Tax payment for lost shares: If you depart the company before your shares vest, you will essentially be paying for something you never got. What’s worse, it is highly possible that you paid taxes on bargain elements upon exercising, paying more than you needed in the process.
- Higher tax payment: In case the stock prices become lower once you exercise your option, there could be a chance that you pair a higher amount of taxes compared to if you did not exercise early. In some cases, people even end up buying the shares for higher rates than they needed, resulting in potential losses.
Wondering how you can use 83b election for your stock options?
83b elections could be handy for people who receive non qualified stock options from their employer. The opportunity to pay capital gains taxes at a lower rate rather than ordinary income makes the NSO 83 b election an attractive option.
However, this proposition has several risks associated with it and some individuals find themselves paying an increased amount of taxes than what they imagined initially. Nevertheless, similar to any type of financial planning, it would be best to evaluate non qualified stock options as a portion of a bigger plan. It shouldn’t just evaluate your decision’s tax impact but also assess your overall cash flow, goals, objectives etc. prioritizing your financial gains for the long-term. And one way to make sure you are managing your NSOs right is by keeping all the details in a Cap Table.
Eqvista is an advanced Cap Table that can help you plan and manage when to exercise your stock options in your company. Our sophisticated platform allows founders to record and track their equity, and share the details with their shareholders. Here are some other important features of Eqvista. To know more about the Eqvista reach us today!