Many companies offer early exercise to employees in an effort to enhance recruiting efforts. Armanino's Equity Management team recently asked Tom Bondi, Tax Partner at Armanino to discuss why allowing an early exercise provision for Incentive Stock Options (ISOs) in your equity plan may not be a good idea.
Tom, can you explain the concept of early exercise?
Early Exercise is the ability to exercise shares under the stock option plan before those shares have vested. The stock acquired through an early exercise is placed under a buyback schedule that allows the company to repurchase any unvested stock should the employee terminate.
What are the advantages to early exercise?
- For Non-qualified stock options (NSOs), employees can file an 83(b) election, and thereby elect to report the tax attributes on the entire award exercise, when the spread between the exercise price and FMV is 0 or close to it (if exercised at grant), and thus the employee has little or no taxes to pay at exercise. There are more complications when it comes to ISOs as discussed further below.
- Exercise proceeds can offer some potential Cash Flow to the company.
- There might be a claim to say that employees are more €œinvested€ because they are owners of stock instead of just holders of options.
- Should dividends be paid to shareholders, those individuals that exercised early would benefit.
- For Incentive Stock Options (ISOs), an employee can start the clock on the holding period requirements (2 years from grant and 1 year from exercise). (Important: See the issues surrounding 83(b) on an ISO early exercise in the notes below.)
What are the disadvantages to early exercise?
- Allowing early exercise on ISOs causes the entire grant to be subject to the IRS $100k ISO limit. (IRC 422(d) states that only $100k worth of ISOs can become exercisable in any calendar year. Early exercise makes them all exercisable.)
- Employee education is required much earlier in the company's life cycle as compared to when a company does not allow early exercise because there is typically much less exercise activity when early exercise is not available. Most employees are unaware or do not understand the Alternative Minimum Tax (AMT) consequences/calculations that come with exercising ISOs.
- While an 83(b) election will apply for AMT (only) to ISOs exercised early, 83(b) elections are NOT applicable for regular tax purposes. So if there is a disqualifying disposition, this becomes difficult to track and report.
- Again, for regular tax purposes, the company must track the Fair Market Value (FMV) or stock price on each vesting date:
- The measurement date for the "one-year from exercise" test for an ISO on an early exercise is the vesting date (not the exercise date).
- For an early exercise, in the case of a disqualifying disposition, the ordinary income component to be reported for regular tax is the difference between the vesting date FMV and the exercise date option price.
- Thus, for those shares within the disqualifying disposition period, the regular tax capital gain calculation is based from the FMV on the vesting date and time from the vesting date (to determine short-term vs. long-term).
- Company's need to record and track an early exercise liability, and have cash available to repurchase unvested options upon termination.
- Employees may have the false sense that if they leave they are able to continue to hold the shares.
- Employees may find on a departure stock repurchase of unvested shares that they incur a non-deductible loss for the taxes paid at exercise on the spread related to the unvested shares.
- Education support for the company to track, report, and communicate to employees timely and correct information related to their options.
- More administrative burden on a company's management, HR, and legal counsel to handle the entire early exercise life cycle (e.g. processes exercises, tax reporting, repurchases, ISO disqualifying disposition tracking, etc.).
- This includes education for the company to properly track, report, and communicate to employees the timely and correct information related to their options.
These are just a handful of the issues that should be considered when determining if an early exercise provision is right for your company's equity plan. Armanino's Equity team would recommend that if you are going to allow early exercise, then to have it apply only to non-qualified grants.
As always, remember that each company's situation is unique so the items above are considerations to take into account and do not constitute tax advice. If you're not sure what option is right for your business and your employees, our experts are happy to help.
