Someone just emailed me the following question (paraphrased): “I have a private company client who has approved a new hire grant to their new CEO that includes early exercise. The total exercise price of the option grant is $180,000 and the CEO is planning to exercise immediately. This would run afoul of the $100,000 rule for incentive stock options (ISOs). So, my question is when exercising the option do we need to indicate in the option exercise notice that $80,000 of the shares are nonstatutory stock options (NSOs)?” Here are my thoughts: When you know an option is going to be early-exercised immediately after grant, it should instead be papered as a restricted stock purchase and a tax code Section 83(b) election should be filed. There are two reasons for this:
1. This avoids tax code Section 409A risk because restricted stock is not subject to Section 409A. Thus, even if you accidentally set the purchase price too low the optionee avoids the 20% penalty.
2. Restricted stock has a >1 year holding period to receive long-term capital gains. On the other hand, to have a qualifying disposition of ISO shares you must hold the shares >2 years from the date of option grant.
If for whatever reason you are gung-ho on papering it as an option, paper it as an NSO. Because there is no spread at the time of exercise this causes no tax and captures the shorter holding period just like the stock grant. My aversion to the NSO approach is simply that it kills more trees because you’ll need an option agreement + notice of exercise + early exercise restricted stock purchase agreement, instead of just a restricted stock purchase agreement. Just like with the restricted stock grant, a tax code Section 83(b) election should be filed.
Mike Baker frequently advises with respect to stock options. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.