Stock options are a form of equity derivative that gives an investor the right (not obligation) to buy or sell the stock of a company in the future at an agreed-upon price and expiration date. Buying or selling the company stock at the agreed-upon price is what we call exercising stock options which can be done early or late. An early exercise of stock options allows the holder of the stock option to exercise his/her options before the expiration date.
Exercising options before the expiration date is permitted in some companies with American-style options. Whereas the European-style options can only be exercised on the expiration date, thus, early exercising is not permitted with this option style.
In this article, we will look at what early exercise of stock options means as well as its benefits and disadvantages.
Related: Types and classes of stocks
What is an early exercise of stock options?
An early exercise of stock options is the process of buying or selling the shares of company stock under the conditions of the option contract before its expiration date. Therefore, in an early exercise of stock options, the option holder exercises the option before the expiration or maturity date.
Some companies allow early exercise of stock options before the options vest. If a company allows this, the holder can exercise his options as soon as he gets his option grant, though the option grant will continue to vest according to the original vesting schedule. However, this is only possible with American-style options and not European-style options.
In American-style option contracts, the holder has the right to exercise his options at any time up to expiration. But for European-style option contracts, the holder may only exercise on the expiration date, thus, early exercise is impossible.
How early exercise of stock options work
Stock options allow the option holders to lock in a price with the company at which the stock can be bought known as the exercise price or strike price. The stock option also comes with an expiration date which is the date after which the option contract between the company and the option holder ends. This expiration period can last for as long as 10 years most times.
After owning stock options, the holder waits to see if the company’s stock increases in value before deciding to pay the exercise price and become a stockholder. The purchase of stocks can be done on the maturity date of the stock option or before the maturity date. If it is done before the maturity date of the stock option, it means the holder has exercised early. Therefore, an early exercise of stock options means investing in the company earlier, with the hopes that the value of the stock will increase in the future.
A person working for a startup or private company may be able to exercise stock options early. By exercising early, the employee buys unvested stock options, just as it is with restricted stock. The early exercise of stock options allows the employee to exercise all or a part of a stock option award before the vesting period. Vesting means earning the right to exercise your options over time. Most times, you can only exercise your stock options after the vesting period, except the company allows early exercising.
Therefore, an option holder electing to exercise early would be required to pay the exercise price before the vesting date in order to own the shares. Both non-qualified stock options (NQSOs) and incentive stock options (ISOs) can contain early exercise provisions. Though, the board of directors must approve the early exercise provision either upfront in the grant agreement or through subsequent modification.
Early exercise of stock options in the right situations can help reduce tax with an 83(b) election and also potentially avoid the alternative minimum tax (ATM) in the case of ISO stock options. Early exercising can also begin the holding period for long-term capital gains earlier. However, it is not in all situations that it makes sense to have early exercise options. Hence, it’s crucial to understand the risks and tax implications associated with early exercise.
For instance, one of the disadvantages of early exercise is that companies can buy back the shares obtained by early exercise if the option holder leaves the company before the option vests. If an employee early exercises and later terminates his service to the company, the company has the right to buy back the unvested stock. The price at which the company buys back the stock is usually generally lower than the exercise price or the current fair market value of the stock. However, this right to repurchase will lapse as the stock vests, meaning that the company doesn’t have the right to repurchase vested stock, only unvested stock.
An example of early exercise of stock options
An investor that owns option contracts of a stock that is trading well above the exercise price may want to buy the stock before the expiration date of the option for tax benefits. Let’s look at Mary’s case as an example.
Miss Mary is awarded 10,000 options to buy the shares of Company XYZ’s stock at $10 per share which is to vest after 2 years. Let’s assume Miss Mary decides to early exercise her stock options and exercises 5,000 of the options and purchases Company XYZ’s stock, which is valued at $15, after a year.
Exercising the 5000 options means she will purchase the shares for $50,000 which is valued at $75,000 in the market. A profit of $25,000 can be made if Miss Mary sells her shares. However, based on a federal AMT rate of 28%, this can cost Mary $7000 tax (i.e 28% of $25,000) on the income from the sale of the shares. Due to this, Mary can choose to reduce the federal tax percentage by holding onto the exercised options (shares bought) for another year to meet the requirements for long-term capital gains tax which will cost her less than the $7000 she would have paid for AMT.
The long-term capital gains tax rate is 0%, 15%, or 20% depending on the taxable income and filing status whereas, the federal AMT is levied at 26% and 28%. From the example, we can see that the early exercise of the stock option before it is vested starts the clock earlier for Mary’s holding period of the stock for long-term capital gains.
See also: Stock options vs equity
Reasons for early exercise of stock options
- Low time value
- Ex-dividend date
- Options are employee stock options (ESOs)
The stock options prices are made up of two components such as intrinsic value and time value. The intrinsic value is the measure of what the underlying stock is worth. Whereas, the time value is the value that the market gives to future potential gains. These two factors play a role in the price of an option and can determine when early exercise will be a better option.
There are instances when an early exercise of stock options makes financial sense. Such instances involve when the stock price is close to the exercise price, when exercising an employee stock option (ESO) early can help avoid AMT (alternative minimum tax) or when the option is nearing its maturity date.
Let’s look at some of these reasons for early exercise of stock options:
Low time value
If an option is close to its expiration date, it may have little to no time value. This usually happens with stocks that have a low tendency for their price to increase or decrease. In such instances, the time value may be low enough to be insignificant in the exercise decision.
Due to this, an option holder may decide to early exercise a call option that is deeply in-the-money (ITM) and relatively near the expiration date. An option is said to be in the money when the fair market value of the stock is more than the exercise price. Since the option is in the money, it will usually have a negligible time value. In such instances, an early exercise may be a good decision.
A pending ex-dividend date of the underlying stock can be another reason for early exercise. The holders of stock options are not entitled to any special or regular dividends paid by the underlying company. Therefore, exercising early can enable the option holder to participate in the stock’s dividends.
A call option holder, knowing that he will exercise eventually may decide to exercise before the ex-dividend date (the date that one has to hold the stock to get the dividend). This, however, only makes sense if the time value of the option is insignificant. Therefore, if there is still time value, it is better to sell the option and buy the stock in a separate transaction.
Options are employee stock options (ESOs)
Early exercise of stock options can be done if the option is an employee stock option. For holders of ESOs in start-ups, it may make sense to exercise employee stock options early for the sake of tax benefits.
There is a favorable tax treatment for ISOs (incentive stock options) when the employee exercise early. The ESOs holder usually qualifies for ISO tax benefits by early exercise. Though, in order to qualify for this tax benefit, the employee has to keep his/her shares for at least 2 years after the option grant date and 1 year after exercising the employee stock options.
Nevertheless, if you hold employee stock options, it is best to consider talking to a financial advisor in order to determine the best plan for your holdings.
Benefits of early exercise
- Early exercise of stock options can reduce the spread and additional taxes
- Exercising early lowers long-term capital gains tax
- Early exercise gives favorable tax treatment for ISOs
- Participation in stock’s dividend prior to the ex-dividend date
There are some advantages of early exercise of stock options such as:
Early exercise can reduce the spread and additional taxes
By the early exercise of stock options, an option holder won’t likely owe additional taxes. If a holder early exercises the stock options as soon as they’re granted, he/she will be purchasing the shares at fair market value. Hence, there is no spread between the current value of the stock and the amount the option holder purchases the stock. This reduces the spread as well as reduces the amount of tax that would have been paid.
For instance, if incentive stock options are exercised early when the exercise price is equal to the fair market value of the option, and an 83(b) election is filed, the spread for AMT tax purposes is $0. Hence, there are no federal tax implications.
Exercising early lowers long-term capital gains tax
Another benefit of early exercise of stock options is that it makes sure the holder starts holding the shares earlier. Therefore, holding the shares for a required period of time causes the income from the sale of the shares to be taxed as a long-term capital gains tax. Exercising early may help the holder pay the lower long-term capital gains tax when he/she eventually sells the shares.
Early exercise gives favorable tax treatment for ISOs
Early exercise of stock options gives favorable tax treatment for ISOs (incentive stock options). By exercising early, the option holder can qualify for ISO tax benefits. However, there are criteria to be met in order to qualify for this tax benefit. The holder has to keep the shares for at least 2 years after the option grant date and 1 year after exercising the stock options.
Moreso, it is important to note that in order to take advantage of this potentially favorable tax treatment, the holder must file an 83(b) election within 30 days of exercising. Should the holder miss this deadline, there could be serious consequences. Making an 83(b) election means requesting that the Internal Revenue Service (IRS) recognize income and levy income taxes on the purchase of company shares when granted, rather than later upon vesting.
Participation in stock’s dividend prior to the ex-dividend date
The holders of stock options are not entitled to any special or regular dividends paid by the underlying company. Therefore, the early exercise of stock can enable the holder to participate in a stock’s dividend prior to the ex-dividend date (the date that one has to hold the stock to get the dividend).
A holder that purchases a stock on its ex-dividend date or after will not receive the next dividend payment. Rather, it is the seller that gets the dividend. But if the option holder purchases stock before the ex-dividend date, he will get the dividend.
Related: Income stock types and examples
Disadvantages of exercising options early
- There is no assurance that the value of the shares will increase
- Cash has to be used for the early exercise of stock options
- Leaving the company after early exercise is unfavorable
- Early exercise of stock options may trigger the $100K rule
In as much as the early exercise of stock options can be advantageous. There are some disadvantages associated with exercising options early such as:
There is no assurance that the value of the shares will increase
Early exercise can be risky because there’s no assurance that the value of the shares will increase in the future. When option holders don’t exercise early and wait for the usual one-year vesting cliff, they can watch the stock’s value in the market; to know if it is increasing or decreasing. This can help give them a better idea of whether they should exercise their options or not. But when options are exercised early and the stock price doesn’t increase in the future, the investor may lose money.
Cash has to be used for the early exercise of stock options
With early exercise, one has to use cash to exercise the option. This means you have to use your own money to purchase the shares. Other cashless methods of exercising stock options are not allowed for early exercise. Therefore, you can’t sell some of your stock or swap stocks to pay for your shares.
Leaving the company after early exercise is unfavorable
Another disadvantage of early exercise of stock options is that it can be unfavorable if the holder leaves the company after early exercising before the stock vests. Companies can buy back the shares obtained by early exercise if the option holder leaves the company before the option vests.
If an employee early exercises and later terminates his service to the company, the company has the right to buy back the unvested stock. The price at which the company buys back the stock is usually generally lower than the exercise price or the current fair market value of the stock. However, it is important to note that the company only has the right to repurchase unvested stock, not the vested stock.
Early exercise of stock options may trigger the $100K rule
It is important to note that early exercise of stock options may trigger the $100K rule (also known as the $100K ISO limit). Triggering the $100k rule means the holder is prevented from treating more than $100K of the full value of his/her grant as incentive stock options (ISOs) in the year that they receive the grant. As a result of this, the value of the option grant that is above $100K is treated as non-qualified stock options (NSOs) for tax purposes.
Early exercise of employee stock options
Early exercise is an important concept in regard to employee stock options (ESOs). ESOs are call options issued to employees as incentives and usually have artificially low exercise prices. If a company allows, employees can exercise their employee stock options before they fully become vested.
Most times, employees that choose to exercise early do so to obtain a more favorable tax treatment. However, they will have to foot the cost to buy the shares before taking full vested ownership. More so, any shares purchased will still have to follow the vesting schedule of the company’s plan.
Employees of recent start-ups may be able to early exercise and purchase shares even while the company’s value is low. An alternative minimum tax (AMT) is charged on the proceed from the difference between the exercise price and the fair market value of the stock. So, the higher the valuation of the start-up company when options are exercised, the higher the related tax bill. Nevertheless, with the early exercise of employee stock options, it may be possible to avoid this alternative minimum tax and short-term taxation since the payment is shifted to the present.
Employees can avoid the AMT by holding on to the purchased stock for a period of time after exercising. There is a holding period required by the IRS which starts when the options are exercised. The employee has to keep the shares for at least 2 years after the option grant date and 1 year after exercising the stock options. This holding period qualifies the income from the sale of the stock purchased through an employee stock option plan to be taxed as capital gain and not wages.
This can be favorable for the employee because the capital gains tax rate is generally lower than the marginal income tax rate. Therefore, the earlier an employee exercises his options, the sooner he can report gains as capital gains.
Early exercise of options tax implications
The early exercise of options has tax implications. If incentive stock options are exercised early when the exercise price is equal to the fair market value of the option, and an 83(b) election is filed, the spread for AMT tax purposes is $0. Hence, there are no federal tax implications. Then, if the regular ISO holding period of holding shares for 2 years from option grant and 1 year from early exercise is met, the entire spread will be taxable as a long-term capital gain.
If the holder doesn’t file an 83(b) election at early exercise, when the shares vest, the spread between the exercise price and fair market value at vesting is income for AMT. Hence, to meet the terms for a qualifying disposition, the holder would need to hold the shares for 1 year after the shares vest (not when the holder early exercised) and 2 years from the grant date.
If the sale of ISOs is a disqualifying disposition, regardless of whether you made an 83(b) election, the tax treatment is likely to be the same. Hence, in the event of a disqualifying disposition of early-exercised ISOs, the spread between the exercise price and fair market value of the stock at vesting is ordinary income for federal tax purposes. Any subsequent gain or loss is a capital gain/loss, depending on the holding period after vesting and the spread between the sale price and the fair market value at vesting.
For early exercised nonqualified stock options (NQSOs) with an 83(b) election, the difference between the fair market value at exercise and the exercise price is taxable as ordinary income and subject to payroll tax. Then, when an employee early-exercises NQSOs without an 83(b) election, there are no tax implications until the stock vests. Then, the spread between the fair market value and exercise price at vesting is taxable. As the stock vests, the capital holding period begins.
A video explaining if the early exercise of stock options is optimal