What are the U.S. federal tax effects of early exercising a nonstatutory stock option?

When an optionee early exercises a nonstatutory stock option to purchase unvested shares, the optionee recognizes ordinary income when the shares vest in an amount equal to the excess, if any, of the fair market value of the shares over the exercise price paid for the shares (the spread), as of the vesting date, unless the optionee timely files a Section 83(b) election or Section 83(i) election (if eligible) with the IRS. The Section 83(b) election treats the unvested shares as vested on the date of transfer for tax purposes, whereas the Section 83(i) election defers the federal income taxes ordinarily due upon exercise for a period of up to five years.

If the shares are later sold or otherwise transferred, any gain or loss recognized by the optionee upon the sale or transfer of the shares generally will be treated as capital gain or loss, and such gain or loss will be long-term or short-term depending on whether the optionee has held the shares for more than one year after the shares vest.

If a Section 83(b) election is properly filed, the optionee instead recognizes ordinary income when the shares are received in an amount equal to the spread, if any, at the time the shares are received. If the shares are later sold or otherwise transferred, any gain or loss recognized by the optionee upon the sale or transfer of the shares generally will be treated as capital gain or loss, and such gain or loss will be long-term or short-term depending on whether the optionee has held the shares for more than one year after the shares were received.

The company is generally entitled to a deduction equal to the amount of ordinary income recognized by the optionee.

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