Early Exercise of ISOs – Why It Doesn’t Work

“Early exercising” refers to exercising a stock option before it has fully vested, so you own the shares sooner (although they remain subject to the same vesting conditions as the stock option). For non-qualified stock options (NSOs), this can be tax-efficient if paired with a timely 83(b) election. Filing the election — now easier with the IRS’ new Form 15620 and electronic filing process[1] — starts your capital gains holding period immediately, often when the “spread” between the exercise price and fair market value of the underlying shares is minimal (or even $0, if exercised soon after the date of grant). This strategy can significantly reduce tax on future appreciation because any subsequent gain will likely qualify for capital gains treatment, either short-term or long-term, depending on whether the shares were held for at least 12 months following exercise.

An incentive stock option (ISO) can qualify for the same favorable capital gains tax treatment as an early exercise NSO that is exercised shortly following grant with a timely filed 83(b) election — but only if strict holding periods are met, which requires that shares acquired upon exercise be held for (i) at least two years from the date of grant and (ii) at least one year from the date of exercise (the “ISO holding periods”). If you sell the shares too soon and you trigger a “disqualifying disposition,” some or all of the gain will turn into ordinary income. For ISOs that have not been early exercised, a disqualifying disposition generally means you would recognize ordinary income at disposition equal to the excess of (i) the lesser of the sale price or the fair market value at exercise over (ii) your exercise price, with any remaining gain being capital gain, long-term if held for more than a year, short-term if not.

Even under the standard ISO rules, meeting the holding periods can be challenging — but once you introduce early exercise, the risks multiply. That’s where the IRS’s restrictive stance on 83(b) elections for ISOs comes into play, and it’s not good news for taxpayers: the IRS has long taken the position that an 83(b) election on ISO shares only counts for alternative minimum tax (AMT) purposes, not regular income tax. This seemingly small nuance can have a dramatic effect on your tax bill.

Specifically, below are some key issues that can arise for ISO holders upon early exercise:

• Disqualifying Disposition: If the ISO is early exercised and the ISO shares are sold in a “disqualifying disposition”, then (i) only vested shares at exercise are taxed under the normal rules for a disqualifying disposition (discussed above) and (ii) the capital gains holding period for unvested shares starts at vesting. For those unvested shares, the spread at vesting is taxed as ordinary income. In a successful, high-growth company, this can significantly increase the portion taxed at ordinary income and short-term capital gains rates, instead of favorable long-term rates.
• After ISO Holding Periods Are Met: Even after the ISO holding periods are met, because the IRS has taken the position that 83(b) elections are only valid for AMT purposes, we generally advise clients that the capital gains period for ISO shares acquired upon early exercise would not begin until the applicable vesting date. For example, if an early exercise ISO vests in four equal installments, is exercised immediately with an 83(b) election, and a liquidity event occurs 3.5 years later, only shares from the first two installments qualify for long-term capital gains; gains on shares from the third installment and any accelerated shares are taxed as ordinary income, potentially creating a substantial additional tax burden.
• Risk of Double-Tax: There is no guaranteed one-to-one offset between AMT paid on ISO shares and the regular income tax owed if those shares are later sold in a disqualifying disposition. As a result, the taxpayer could end up paying both AMT and ordinary income tax on the same spread, leading to a partial double tax.
• Control Over Disqualifying Disposition: You may have no control over when a disqualifying disposition occurs — it can be triggered by a company sale, accelerated vesting, or share repurchase.

Bottom line: The early exercise + 83(b) approach that can work well for NSOs simply does not work for ISOs. In many cases, it increases your tax bill instead of reducing it. So, the choice is clear: we recommend against granting early exercising ISOs.

[1] For more on 83(b) mechanics and the new IRS procedures, see MoFo’s recent client alert on the updated rules for making 83(b) elections.