I’m going to tell this story as if it happened to you.

You’re hired as an employee at Start-up X, VC backed, whippersnapper CEO, SAAS industry, Uber for X business model, etc.  Along with a salary are 1,000 incentive stock options (ISOs). Woo hoo, you’re on the road to growing an amazing business and participating in the equity (ownership) of the business. There are many ‘decision trees’ you’ll want to consider but one of them is whether to early exercise your ISOs, and with that decision, whether to file an 83(b) election.

(For the purposes of this blog I’m going to assume you’ve done all your homework and are familiar with the terms related to stock options. If you aren’t, by all means join the narrative, but you may have to backfill for understanding some of the terms.)

With the grant of the ISOs to you comes an exercise price (the price at which you can pay to convert the ISOs into shares of stock), a vesting schedule (the period of time you must stay an employee of the company to actually take ownership of any equity) and an expiration date (N/A for this story…but basically the last day you have to exercise the ISO, aka the last day to convert the ISOs into shares).

So, on the grant date of your ISOs, the exercise price was the same price as the Fair Market Value (FMV) of the company stock. The FMV of the company stock was determined through a 409A valuation performed by a 3rd party (but could have been determined by the Board, either way, the option grant exercise price was issued at the FMV to attract you and others like you to join Start-up X).

On the grant date, when you receive the 1,000 ISOs, you contact HR and let them know you want to early exercise. They let you know that yes, indeed, Start-up X does let employees early exercise (not all companies do). HR says you have to complete a form requesting early exercise and pay Start-up X $1,000 ($1 exercise price * 1,000 ISOs) to receive your 1,000 ‘restricted’ shares.

(Why ‘restricted’ shares? Because your ISOs/shares have not vested yet. Your vesting schedule is 50% year 1 and 50% year 2. So, technically, if you don’t stay as an employee for 2 years then you wouldn’t ‘vest’ your stock ownership).

Cool, but the timer is ticking. You have 30 days from the early exercise transaction date to file an 83(b) election.

You’ve already decided that you think Start-up X stock is going ‘to the moon’ so you send the Internal Revenue Service (IRS) the following information postmarked within 30 days of the early exercise transaction:

  • 83(b) election
    • a letter stating your intent to make the 83(b) election, including:
      • your name and taxpayer identification number and address
      • description of shares
      • the date of the early exercise transaction
      • the amount paid for the shares
      • the number of restricted shares granted
      • the fair market value of the restricted shares on the date of the early exercise transaction.
  • copy of ISO Agreement
  • copy of payment receipts, proving your payments for the ‘restricted’ shares
  • valuation proof from company – could be a letter from HR of Start-up X stating the FMV based on the 409A valuation.

Once you filed your 83(b) election, you are now subject to income tax on the difference between the  exercise price of your ‘restricted’ shares and FMV of the shares at the date of the early exercise. The cool thing here is that the FMV was equal to the exercise price on that date so you actually don’t owe any income tax on the transaction in your case. Score.

(It is important to note that an 83(b) election is irrevocable. Once you have filed your election, you cannot change your mind.)

So, then what happened next?

In the year of exercise you received a form 3921 to help you complete your tax return. It had the following info:

  • grant date of the ISO
  • exercise date
  • exercise price
  • FMV on exercise date
  • number of shares exercised.

You paid no income tax because the exercise price and FMV were both $1 on the date you early exercised (again, score).

You held your shares for 2 years. 50% were released from restriction after year 1 and the remaining 50% of the shares were released from restriction after year 2. Once you were fully vested, the company had already raised 2 more funding rounds and the FMV of the shares were now $10.

At that point you chose to sell your shares (post vesting) and made $9 per share. You paid long term capital gains tax on $9,000 ($10 FMV at sale date – $1 Cost basis from early exercise) * 1,000 shares = $9,000.

Why was it beneficial that you filed an 83(b) election?

  • You didn’t have to pay ordinary income tax (and AMT) on the date of early exercise.
  • You locked in your cost basis for the restricted shares on the date of the ISO early exercise, with the value of the shares increasing after that date.
  • You deferred paying capital gains taxes on the restricted shares until you sold them.
  • You paid long term capital gains tax vs. short term capital gains tax.
  • You avoided the 10% penalty tax that is imposed on employees who sell restricted shares or stock within one year of vesting.

So, was it a good choice? Well, for you, within these precise sets of circumstances, yes, it was the most tax advantaged choice you could have made. Would it be in all scenarios? No. Tweak any one of the many metrics and the outcome would change. The most existential metric would be if Start-up X died a year later then you would have paid $1,000 to early exercise your ISOs and they’d be worth nothing.

There is no moral to this story other than to educate yourself and make the choices that make the most sense for you. Good luck and God bless.