TLDR
By using the ISO Tax Form & 83(b) rule you can reduce AMT tax (Alternative Minimum Tax) and considerably lessen your regular taxes.
Venture backed startup companies are big fans of using stock options as a major compensation tool to attract and retain employees. Companies often allow early-exercising of unvested stock options because the tax savings are a significant benefit and the invested capital is a demonstration of commitment by the employee. If your company's stock value rises over the years, you can avoid two major tax issues by having exercised early. First is the ever-increasing AMT liability if the Fair Market Value of your stock rises before you finally exercise. Second is qualifying for long term capital gains based on the exercise date when you actually invested as opposed to the subsequent vesting date. To solve the latter problem, you need to file an 83(b) election (ISO tax form) within 30 days of your exercise date or else taxes will be computed when the possibility of forfeiture goes away (your vesting date) and the FMV is usually higher at the future vesting dates. A higher FMV results in higher taxes even though you exercised at an earlier date.
Benefits of Filing ISO Tax Form Early
Filing an 83(b) with the IRS means that you are bound to consummate your intended stock purchase. The IRS isn't capable of tracking whether you actually leave the company early resulting in a repurchase of the unvested stock, so they simply subject you to the applicable taxation up front based on your expressed intent. However, your cost basis and the fair market value are equal up front so there shouldn't be any taxes due. The exception is if you waited some period of time before executing the early exercise and the fair market value of your company's stock at the time of exercise had risen above your option grant strike price. Even then, you may or may not be subject to tax depending on several factors such as whether these were qualified ISOs, the implied gain in value, and your level of income. Establishing the purchase date right away also makes the stock eligible for long term capital gains (LTCG) treatment after it is held for at least one year and at least 2 years has passed since the date of the option grant. There is a 20% federal tax savings associated with LTCG but drops to 15% if you are in the highest tax bracket. Although there are no additional tax savings for California because capital gains and ordinary income are taxed at the same rate, there are many other states that do provide an additional tax savings for LTCG. This savings was still applicable in 2015 but is subject to removal or reduction during each election cycle so please see a tax professional for the latest rules.
There is no special form for filing an 83(b) but a sample is provided here. You are cautioned to review this with your tax advisor for compliance with your particular situation since IRS rules are continually subject to change. Send 2 copies to the IRS along with a self-addressed stamped envelope for them to return a stamped acknowledgment. Keep a copy for your records at least until you received the stamped acknowledgment from the IRS. You no longer have to file a copy with your return to encourage e-filing but the applicability to you is an important thing to verify with your tax advisor.
Founders Stock
It is common for founders and early employees to get stock grants that are subject to repurchase by the company if they don't stay around long enough to vest. For these people, it is usually favorable to make an 83(b) election and pay the relatively small amount of taxes that would be due while the stock still has a low FMV. For example, a founder could get a grant of 1 million shares at a PAR Value of $0.001 per share which means they will elect to recognize $1,000 of ordinary income associated with the grant during the initial tax year. Alternatively, they can invest $1000 and recognize no income but an 83(b) is still required. The savings from long term capital gains can be extraordinary down the road when these same shares are sold for a high value which means the ROI on those initial taxes can be very high. If the founder's stock grant isn't subject to re-purchase then the 83b isn't necessary but it is common for venture capital investors to request a vesting period as a condition of investment.
Selling Shares is a Taxable Event
Exercising stock options early can require a lot of capital and yet the time to liquidity for your company can be quite long. As your shares are vested, you may be tempted to sell some shares to recover your original investment or perhaps fund other financial needs. Be aware that a sale is likely a taxable event and usually at high tax rates. A sale also truncates any possibility of future upside on the shares being sold. An alternative solution is to get an advance from the ESO Fund to help cover your tax burden. A key benefit of an ESO transaction is no repayment is due until a liquidity event is reached on the stock. Furthermore, if the stock becomes worthless, ESO absorbs the loss, not you.
See here for more information on tax savings. For help funding exercise related taxes, check out how ESO Fund can cover your taxes risk-free.
