If I grant early exercise options, should I grant the options as incentive stock options or nonstatutory stock options?

It depends. If the optionee will exercise the option immediately to purchase all of the shares covered by the option while they are unvested, the optionee will be better off with a nonstatutory stock option (NSO). In that case, the optionee can file a Section 83(b) election with the IRS. The election treats the unvested shares as vested on the date of transfer for tax purposes. There likely will be no difference between the exercise price and the fair market value on the date of exercise, and therefore the optionee will not have to pay any U.S. federal taxes. The optionee will need to hold the shares for more than one year to receive long-term capital gains treatment.

In contrast, an optionee who immediately exercises an incentive stock option (ISO) will not recognize any income in connection with such exercise, but the optionee will need to hold the shares for more than two years to meet both of the necessary holding periods and receive long-term capital gains treatment. If the optionee fails to do so, the optionee will recognize ordinary income equal to the excess, if any, of the fair market value of the shares over the exercise price paid for the shares at exercise.

With respect to ISOs that are early exercised, a Section 83(b) election is available only for purposes of the alternative minimum tax (AMT), and the election will affect the timing and amount of the optionee’s AMT adjustment, if any, in connection with the ISO exercise, but will not start the 12-month clock for long-term capital gain treatment. That 12-month clock begins on the vesting date, and not the date of early exercise. Since the vesting date is later than the date of early exercise, there is an increased likelihood that any capital gain on a disqualifying disposition will be short-term capital gain and taxed as ordinary income.

If the optionee meets the necessary holding periods for favorable U.S. federal tax treatment, then the full difference between the sale price and the exercise price is recognized as long-term capital gain, which is the same treatment the NSO holder would receive if he or she early exercised right after grant, when there was no spread between the exercise price and the value at exercise, and he or she had timely filed a Section 83(b) election. The only difference is that the NSO holder would have only had to have held the shares just over one year before selling, while the incentive stock option holder would have had to hold the shares more than two years from the grant to receive the same federal tax treatment.

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