Q: I just exercised a vested stock option. Do I now have to make a Section 83(b) election?
A: No, unless your company’s stock option plan documents contain unusual or atypical provisions. Typically you do not have to make a Section 83(b) election on shares you acquire upon the exercise of a vested stock option. (The same is not true for the exercise of an immediately exercisable stock option, which allows an optionee to exercise an option and acquire unvested shares.)
The reason you don’t have to make an 83(b) election on the exercise of a vested stock option is because the shares acquired, being vested, are not subject to a substantial risk of forfeiture under Section 83 of the Internal Revenue Code.
Section 83(a) says the following:
“Substantial risk of forfeiture” – The rights of a person in property are subject to a substantial risk of forfeiture if such person’s rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual.
If, in the connection with the performance of services, property is transferred to any person other than for whom such services are performed, the excess of –
- the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of a person having the beneficial interest in such property are transferrable or are not subject to a substantial risk of forfeiture, whichever occurs earlier over the amount (if any) paid for such property,
- shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or not subject to a substantial risk of forfeiture, whichever is applicable.
The regulations add a little detail to this. For example, the regulations provide that “[p]roperty is not transferred subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value of a portion of such property to the employee upon the return of such property.”
In general, the answer to this question is found in the statute itself, in the provisions quoted above.
If you are exercising a vested option, consult with your tax advisors to confirm, but a Section 83(b) election should not be required.
Congratulations, you’ve gotten your company off the ground. You’ve incorporated, issued founder shares and filed 83(b) elections, adopted a stock option plan, granted stock options, and been working on your business for a while. Now an employee who has been with you since the start wants to exercise a stock option that has vested in part. What do you do?
I recommend that you take the following steps as you process each option exercise:
- Review the stock option exercise notice; confirm that it is completed correctly and executed by optionee.
- Make sure that you have all of the optionee’s original stock option paperwork signed and in the files (meaning, the notice of grant of stock option or stock option agreement).
- Confirm that option was approved by the Board in minutes and/or a Board consent.
- Confirm that your Rule 701 math was correct, and that you are operating within Rule 701′s limitations and conditions.
- Was the optionee terminated and in connection therewith did the optionee execute a release of all claims? If so, did the release terminate the stock option?
- Confirm the tax status of the option being exercised—nonqualified stock option (NQO) or statutory (incentive) stock options (ISO)? Is it in part an ISO and in part an NQO?
- Make sure the optionee is only exercising with respect to vested options or options that are not vested but immediately exercisable.
- Confirm Blue Sky securities law compliance. (In which state does the optionee reside? Are securities filings required?)
- Does the Company have a repurchase option with respect to the shares? Will the Company exercise its repurchase option?
- Determine whether the Board of Directors needs to make a new determination of the fair market value of the shares to determine the tax withholding or ISO adjustment amount.
- Calculate the tax withholding (including but not limited to federal income and federal employment) if the option is an NQO (if the option is an ISO, make sure employee understands AMT tax consequences and be sure to send notification of ISO gain to employee and IRS).
- Make sure to obtain from the exercising optionee the strike price plus the tax withholding, if tax withholding is required.
- Consider providing the optionee with disclosure of some of the material risks of buying the securities. A bullet point list of risk factors, financial statements, for example.
- Have Company counsel prepare a stock certificate and stock certificate receipt.
- Update the Company’s capitalization table.
- Make sure payroll is aware of the exercise and properly reports the exercise on wage statements/Forms W-2, or ISO adjustment notification.
Don’t rush through this process and miss an important step!