What are the U.S. federal tax effects of early exercising an incentive stock option?

An optionee generally does not recognize taxable income when he or she early exercises an incentive stock option (ISO), but the difference between the option exercise price and the fair market value of the purchased shares is an adjustment for alternative minimum tax (AMT) purposes. If the optionee does not sell or otherwise transfer the shares purchased through such exercise within two years after the date of grant or within one year after the date of exercise, then upon the sale or transfer of such shares, any gain will be treated as long-term capital gain (which is taxed more favorably than ordinary income).

However, if the optionee sells or transfers the shares before meeting both of the holding periods described above (a disqualifying disposition), generally the optionee will recognize ordinary income in an amount equal to the excess, if any, of the fair market value of the shares on the vesting date (or, if less, the amount realized on the sale or transfer of the shares) over the exercise price of such shares.

Any further gain or loss realized by the optionee will be taxed as short-term or long-term capital gain or loss, as the case may be. The 12-month clock for long-term capital gain treatment begins on the vesting date, and not the date of early exercise.

Please be aware that the early exercise of ISOs may affect the determination of an optionee’s AMT. When an optionee exercises an ISO, he or she will be required to include the 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 as an adjustment item in the determination of his or her AMT, unless such person timely files a Section 83(b) election with the IRS. The election treats the restricted stock as vested on the date of transfer for tax purposes.

However, if the optionee sells or transfers the shares in the same calendar year as the date of exercise of the ISO, then no adjustment with respect to those shares is included in the determination of the optionee’s AMT.

If a Section 83(b) election is timely filed, the optionee’s AMT adjustment is based upon the spread at exercise. With respect to ISOs that are early exercised, a Section 83(b) election is available only for AMT purposes, and the election will not start the 12-month clock for long-term capital gain treatment. Determination of the AMT is complex and highly dependent on the optionee’s individual situation. As a result, optionees should consult with their tax advisers before early exercising any ISOs to understand the tax consequences of early exercising ISOs and the sale or transfer of shares.

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