There are two major differences between incentive stock options (ISOs) and non-qualified stock options (NSOs): the type of person who may receive the option award and the tax consequences upon option exercise. This is not to suggest that there aren’t other technical distinctions but, this post will address only these two. It also reviews the benefit of the 83(b) election.
ISOs can only be granted to employees. NSOs can be granted to anyone: employees, independent contractors and directors. Because bootstrapped startups typically rely on service providers who are independent contractors and not employees, they will typically be issuing NSOs—not ISOs.
There is typically no income tax event when the ISO or NSO is granted, and thus no tax difference at time of award (but see the discussion below, “The Benefit of the 83(b) IRS Election” ). The major tax differences between ISOs and NSOs arise when the option is exercised, meaning when the stock is purchased.
When an ISO is exercised, no taxable ordinary income results (subject to the Alternative Minimum Tax “AMT” Rules). In contrast, when an NSO is exercised, the positive difference between the fair market value (FMV) of the stock at the time of exercise and the option exercise price (the “spread” or “in the money” amount) will be recognized as compensation and ordinary income to the option holder. This occurs as a taxable paper gain even though the option holder does not then sell any of the shares purchased.
For the employer, employee NSO exercises are subject to withholding for employment taxes, and the company can generally deduct, as a compensation expense, the ordinary income recognized by the option holder upon exercise of the NSO.
If the shares acquired on exercise of an ISO are held for more than one year after the date of exercise and for more than two years after the date of the option’s grant, then the gain or loss resulting from a sale of the shares will be taxed as long-term capital gain (or loss). However, if a “disqualifying disposition” occurs (meaning the ISO shares are sold before the expiration of this two-prong holding period), the option holder loses the beneficial ISO tax treatment, and the ISO is now taxed as an NSO. This results in the option holder incurring taxable ordinary income to the extent the fair market value (FMV) of the shares at the time of exercise (purchase) exceeds the exercise price. Unlike a true NSO, however, the former ISO remains exempt from employment taxes.
Some startups permit option holders to early exercise and purchase their option shares before they vest. The purpose of doing so, when combined with a timely 83(b) election, is generally to avoid the potentially adverse tax consequences to the option holder upon NSO exercise. When a company permits early exercise it will generally retain a contractual right to repurchase the “unvested” stock upon termination of employment at the exercise price the employee paid.
If an employee early exercises an NSO but fails to make a timely so-called 83(b) election with the IRS, he or she may incur regular taxable income as the stock “vests.” The taxable income is equal to the positive “spread” between the share’s FMV at the time of vesting and what was paid for each share (the exercise price). The taxable income could be substantial if the value of the shares has increased substantially over time.
Under an 83(b) election, the option holder “elects” to accelerate the timing of recognition of income from the date the stock “vests” (the date company’s repurchase right lapses as to any given shares) to such earlier date when the holder exercised and purchased the shares. This is advantageous because, generally, companies set the exercise price at an amount equal to Board’s determination of the FMV of one share at the time of grant. So if one early exercises and accelerates the date for recognizing income to a time when the exercise price and the FMV of a share are the same, there is no “spread” to tax.
For example, assume that an option holder receives an NSO subject to four year vesting with a one year cliff and an exercise price of $0.02/share. The option holder then early exercises (purchases) the stock promptly while the FMV of each share acquired was also $0.02. But assume further that the holder does not make a timely 83(b) election with the IRS, and, at the end of the one year cliff, 25% of the shares vest when the FMV is $1.00/share.
Even though the holder does not then sell any of the vested stock, he or she would recognize $0.98/share of regular taxable income as to the vested shares. As the remaining stock vests monthly, the holder would recognize income as to newly vested shares in an amount equal to the difference between the then FMV and the $0.02/share paid at early exercise. In addition, the company would be required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.
In contrast, had the option holder made a proper 83(b) election in connection with his or her early exercise, he or she would not recognize any income as the stock vests—because, as noted above, he or she would have elected to accelerate the timing of income recognition from the date of vesting to the earlier date of exercise (purchase) when the exercise price and FMV were the same, in this example, $0.02/share.
In order for an 83(b) election to be effective, the option holder must file the election with the IRS prior to the date of the stock purchase or within 30 days after the purchase date. To my knowledge, there are no exceptions to this timely filing rule.
The last possible day for filing is calculated by counting every day (including Saturdays, Sundays and holidays) starting with the next day after the date on which the stock is purchased. For example, if the stock is purchased on June 15, the last possible day for filing is July 15 . The postmark date of mailing is deemed to be the date of filing. The election should be filed by mailing a signed election form by certified mail, return receipt requested to the IRS Service Center where the individual files his or her tax returns. A copy of the election should be provided to the company, and another copy attached to taxpayer’s federal income tax return for the year in which the stock is acquired.
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