When does it make sense to exercise your stock options in a private venture backed company?

With stock options, there are two dates that are of utmost importance, the grant date (the date that the options were granted to you) and the exercise date (the date that the exercise was made). Also, the stock prices you need to keep track of as well is the stock prices on the two dates above, and the stock price on sale.

The general rule for options is that if you exercise and hold, it is a qualifying disposition if the sale date is the later of two years from the date of grant and one year from the date of exercise. A sale that does not meet this time frame is called a disqualifying disposition. There are also two types of stock options, ISO’s (incentive stock options) and NQ’s (nonqualified stock options). For regular tax purposes, ISO’s and NQ’s are treated the same way. However, for AMT tax purposes, ISO’s are taxed when exercised, not sold. You need to keep this mind because this is where a lot of people who became wealthy because of incentive stock options found themselves in a hole, owing the IRS a lot in taxes.

In a qualifying disposition, the gain on the sale is the spread between the selling price and the price on the date of grant. Also, this spread is taxed as long term capital gains. In a disqualifying disposition, the spread between the price on the date of grant and the date of exercise is taxed as ordinary income, and the spread between the sales price and the date of exercise is treated as capital gains (long-term or short-term depending on the length of time between the exercise date and the date of sale).

With a 83(b) election, the taxpayer is electing to be taxed on income from the stock options when it is exercised, and not when it is sold. So while you would normally not be taxed on the stock options until it is sold, you are electing to be taxed upon exercise. You generally see this when a company allows the employee to do an early exercise of stock options. In order to have a valid 83(b) election, the election must be made with the IRS within 30 days of the exercise.

To put some numbers to the above:

Number of shares: 1,000
Grant: January 31, 2007 at $10 per share
Exercise: January 1, 2008 while stock was at $12 per share
Sales price: $50 per share

In the above example, if the exercised stock was sold on February 2, 2009, it would be a qualifying disposition, and the difference between sales price and the price paid of $40 ($50 less exercise price of $10) times 1,000 shares gives you a taxable gain of $40,000. This gain is taxed as long term gains.

Now, if we sell the stock on January 15, 2009, it would be a disqualifying disposition, and the taxable gain is $2,000 taxed as ordinary income, which is taxed at the employee’s highest marginal rate, and the remaining $38,000 is taxed as long term gain. While the holding period met the standard of one year from the date of exercise, it did not meet the holding period of two years from grant, so the $2 spread between grant and exercise is taxed as ordinary income. Since it did meet the one year from date of exercise, the $38 spread between exercise and sale is taxed as long term capital gains. This tax treatment applies for regular tax purposes regardless of whether the options are ISO’s or NQ’s.

If the stock options were ISO’s, then the $2 spread between grant and exercise is taxed for AMT tax purposes in the year in which it was exercised (2008). It doesn’t matter whether it was sold or held.

Now let’s look at how the 83(b) election would come into play. Using the same numbers and dates above, assume that the employee exercises the stock early on October 1, 2007 when the stock price was $10.01. The 83(b) election is made and the employee recognizes the 1 cent spread per share as income ($10). This income is reported for both AMT and regular tax purposes. When the times comes for the stock to be sold, the employee’s basis in the stock is $10.01 per share, or $10,010 (his basis increases by the $10 he recognized as income). So, his gain on the sale is $39,990. With the 83(b) election in place, the 2 years from date of grant requirement becomes meaningless (since he had already elected to be taxed with the 83(b) election). So the only date we need to worry about is the one year from date of exercise. If he meets that, then the entire $39,990 in gain is taxed as long term capital gains and he gets favorable tax treatment.