Early Exercise

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Early Exercise

What is Early Exercise?

Early exercise of an options contract is the process of buying or selling shares of stock under the terms of that option contract before its expiration date. For call options, the options holder can demand that the options seller sell shares of the underlying stock at the strike price. For put options, it is the converse, where the options holder may demand that the options seller buy shares of the underlying stock at the strike price.

Understanding Early Exercise

Early exercise is only possible with American-style option contracts, which the holder may exercise at any time up to expiration. With European-style option contracts, the holder may only exercise on the expiration date, making early exercise impossible.

Most traders do not use early exercise for options they hold. Traders will take profits by selling their options and closing the trade. Their goal is to realize a profit from the difference between the selling price and their original option purchase price.

For a long call or put, the owner closes a trade by selling, rather than exercising the option. This trade often results in more profit due to the amount of time value remaining in the long option lifespan. The more time there is before expiration, the greater the time value that remains in the option. Exercising that option results in an automatic loss of that time value.

Key Takeaways

  • Early exercise refers to buying or selling stock shares before the expiration of contract options.
  • It is only possible with American-style options.
  • Early exercise makes sense when an option is close to its strike price and close to expiration. Employees of startups and companies can also choose to exercise their options early to avoid the alternative minimum tax.

There are certain circumstances under which early exercise may be advantageous for a trader.

For example, a trader may choose to exercise a call option that is deeply in-the-money and is relatively near expiration. Because the option is in-the-money, it will typically have negligible time value.

Another reason for early exercise may be a pending ex-dividend date of the underlying stock. Since options holders are not entitled to either regular or special dividends paid by the underlying company, this will enable the investor to capture that dividend. It should more than offset the marginal time value lost due to an early exercise.

Employee Options

There is another type of early exercise that pertains to company awarded stock options (ESO) given to employees. If the particular plan allows, employees may exercise their awarded stock options before they become fully vested employees. A person may choose this option to obtain a more favorable tax treatment.

However, the employee will have to foot the cost to buy the shares before taking full vested ownership. Also, any purchased shares must still follow the vesting schedule of the company’s plan.

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The money outlay of early exercise within a company plan is the same as waiting until after vesting, ignoring the time value of money. However, since the payment is shifted to the present, it may be possible to avoid short-term taxation and the alternative minimum tax (AMT). Of course, it does introduce the risk that the company may not be around when the shares are fully vested.

Example of Early Exercise

Suppose an employee is awarded 10,000 options to buy company ABC’s stock price at $10 per share. They vest after two years. She exercises 5,000 of those options to purchase ABC’s stock, which is valued at $15, after a year. Exercising those options will cost her $7,000 based on a federal AMT rate of 28%. However, she can reduce her federal tax percentage to 15% (based on 2020 rates) by holding onto the exercised options for another year to meet requirements for long term capital gains tax.

Early Exercise

Early Exercise (assignment)

Early Exercise

early exercise

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Unexpected Risks of Early Exercise ISOs

Companies that permit the grant of early exercise incentive stock options (“ISOs”) do so primarily to limit the impact of the alternative minimum tax (“AMT”). However, due to fairly counterintuitive tax regulations, structuring options in this fashion can expose optionees to negative tax consequences in the event of a disqualifying disposition. This eUpdate reviews the tax effects of early exercise ISOs and compares the tax results to alternate structures.

Early Exercise ISO Tax Consequences

With any early exercise option, the optionee exercises the option by paying the exercise price but receives back restricted stock with the same vesting schedule as the original option. Employees will usually file a Section 83(b) election as permitted within 30 days following the transfer of the restricted stock. In 2004, final ISO regulations clarified that Section 83(b) elections filed on restricted stock acquired via early exercise ISOs are only effective for AMT purposes and not for ordinary compensation tax purposes. In the best case where both ISO holding periods are met (the shares acquired via ISO are held at least two years from the date of grant and at least one year from the date of exercise, prior to sale), the entire spread between the sale price and the exercise price paid will be taxed as long-term capital gain. However, if either holding period is not met, a “disqualifying disposition” occurs. Assuming that an 83(b) election was timely filed within 30 days following exercise, then upon a disqualifying disposition, the difference between the fair market value of the shares on the date the underlying restricted stock vests less the exercise price paid for the shares is compensation income which will be reported on the employee’s Form W-2 in the year of sale (or if less, the amount realized in the sale less the exercise price). 1 In addition, the capital gains holding period will only begin on the date the underlying restricted stock vests. 2 To the extent the stock price increased or decreased from the date of restricted stock vesting, such change will be short-term or long-term capital gain or loss, as applicable.

This tax result means that early exercise ISOs become risky to an optionee in the event of a disqualifying disposition. While reducing AMT income is a positive result, a disqualifying disposition results in a potentially large amount of compensation income and/or short-term capital gain. The optionee often has little control over whether a disqualifying disposition will occur, such as if all shares are sold in connection with an acquisition of the issuer or if the optionee’s shares are repurchased following termination from employment.

Early Exercise NSO Tax Consequences

As compared to an ISO, the exercise of a non-qualified stock option (“NSO”) is not a preference item for AMT purposes. If an optionee early exercises a NSO, an 83(b) election will be respected for compensation purposes and the optionee will only recognize compensation income equal to the fair market value of the shares on the date of exercise less the option’s exercise price. This income will be subject to applicable withholding for federal and state payroll taxes, including FICA. However, if the option is early exercised shortly following the option grant date, as is often the case, there is typically minimal (or zero) spread to recognize as compensation up front. The 83(b) election also starts the capital gains holding period. Thereafter, the vesting of the underlying restricted stock received upon the early exercise will not result in any further compensation income to the optionee. Upon disposition of the stock, capital gain or loss will be recognized in the year of sale, which will be long-term if the stock is held at least one year from the date of early exercise.

Therefore, in contrast to early exercise ISOs, early exercise NSOs can reduce the exposure to gain being characterized as short-term capital gain to the one year after the early exercise, provided the 83(b) election is timely filed. In addition, by exercising and filing an 83(b) election shortly following grant, recognition of compensation income may be limited or eliminated. Early exercise ISOs have an overhang for up to two years following the date of grant where a disqualifying disposition could result in both compensation income and short-term capital gain recognition. For these reasons, as illustrated in the examples below, we find early exercise NSOs to be preferable to early exercise ISOs in most cases. This is especially true with respect to companies where (i) there is a possibility of acquisition within two years following the date of grant, (ii) the optionees have sufficient capital to early exercise the awards and (iii) the optionees see a meaningful upside for the company at the time of early exercise (or the amount needed to early exercise is relatively small).

A startup company grants early exercise ISOs for 1000 shares to an employee at $0.05 per share on June 1, 2020 subject to a vesting schedule where 50% vests on June 1, 2020 and the remaining 50% vests on June 1, 2020. Participant early exercises on June 5, 2020 while shares are still worth $0.05 per share and files an 83(b) election recognizing $0 in income, which is effective only for AMT purposes. Upon exercise, the participant receives restricted stock with the same two-year vesting schedule. When 50% of the shares vest on June 1, 2020, the fair market value has risen to $5 per share. On March 1, 2020, the company is sold via a stock purchase agreement for $10 per share. All unvested equity awards are accelerated and the shares held by the participant are sold in the deal, resulting in a disqualifying disposition, as both ISO holding periods were not met.

  • Participant recognizes compensation income equal to the spread between FMV on the date the restricted stock vested less the exercise price paid: For the 500 shares that vested on June 1, 2020, 500 x $(5.00 – .05) = $2,475. For the 500 shares that vested in connection with the March 1, 2020 transaction, 500 x $(10.00 – .05) = $4,975. Total compensation income recognized due to disqualifying disposition is $2,475 + $4,975, or $7,450.
  • The capital gains holding period begins on the date of restricted stock vesting. Because both tranches of restricted stock vested less than a year prior to the March 1, 2020 transaction, the $10,000 received in the stock sale less (i)$7,450 previously recognized as compensation income and (ii) $50 in total exercise price paid, or $2,500, is short-term capital gain.

Assume the same facts as Example 1, but with an early exercise NSO instead:

  • The 83(b) election on June 5, 2020 results in $0 in compensation recognition and also begins the capital gains holding period.
  • No compensation income is recognized with the vesting of the underlying restricted stock, as there is no disqualifying disposition concept applicable, and the 83(b) election was effective for compensation tax purposes.
  • Upon the sale of the company on March 1, 2020, the entire $10,000 received minus the $50 amount paid in exercise price, or $9,950, will be recognized as long-term capital gain.

Assume the same facts as Example 1, but with a regular ISO grant (without the early exercise feature) that is exercised immediately prior to the March 1, 2020 transaction:

  • No compensation income recognized at the time of exercise under the ISO rules.
  • The March 1, 2020 sale of the shares will be a disqualifying distribution, characterizing the full $10,000 received minus the $50 amount paid in exercise price, or $9,950, as compensation income.

1 Treas. Reg. Sec. 1.422-1(b), Ex. 2.
2 Id.

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