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Hypothetical scenario:

  • 10k option grant size
  • the grant price (and FMV/409a valuation at grant time) is $1.00
  • assume $2.00 FMV at time of exercise/purchase

If these options are early exercised (and an 83b is filed) then the grantee owes income taxes (at marginal rates) on the difference ($1) times 10k.

Now assume these shares are vested, held for at least 1 year, and are then sold for $5 each. Everything I've read implies that the grantee now owes long-term capital gains taxes on the difference, which would be 10k * ($5 - $1).

But, if that's the case... then let's look at the example where the stock is granted at $1, exercised when the FMV is $2, then again held for at least a year but then sold for $2.

By the analysis above, the grantee would owe marginal/income taxes at the time of exercise on $10,000, and then ALSO owe long-term capital gains taxes on $10,000 also.

Can this be correct? It seems at first glance like double-taxation, but it's more than possible that I'm missing a rule somewhere. Is there some way to "credit" the part of the gain that is taxed when the early exercise is done?

If this were the case, then in the first example (sale at $5) then the grantee would owe marginal rates on 10k, and long term rates on 30k. In the second case (sale at $2) then the tax would be.... the long term part less the marginal part?

How on earth is this actually accounted? ;-)

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Now assume these shares are vested, held for at least 1 year, and are then sold for $5 each. Everything I've read implies that the grantee now owes long-term capital gains taxes on the difference, which would be 10k * ($5 - $1).

No. That's exactly what the SO is NQ for. Read more on the differences between ISO and NQSO here.

Now assume these shares are vested, held for at least 1 year, and are then sold for $5 each. Everything I've read implies that the grantee now owes long-term capital gains taxes on the difference, which would be 10k * ($5 - $1).

At this point you no longer have NQSO, you have RSU. If you filed 83(b) when you exercised, then you pay capital gains tax when they vest. If you didn't - its ordinary income to you. NQSO is a red herring here since once exercised they no longer exist.

If you didn't file 83(b), then when the stock vests the difference between the FMV at vest and the money you spent on it when exercising (if any) is considered wages and taxed as ordinary income (+FICA etc). From that point the RSU becomes a regular stock investment and the capital gains clock starts ticking.

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  • I read that - but I don't see anywhere that it addresses the original question. I'm aware of the differences between non-qualified and incentive options, what is not clear is how the early exercise provision changes the tax consequences of NQ options specifically.
    – ljwobker
    Jan 19, 2015 at 19:13
  • I don't think I understand. Your question was "If X happens then how is Y handled", I answered "X never happens". I was assuming you'll understand that the rest of your question is moot. What is not clear?
    – littleadv
    Jan 19, 2015 at 19:37
  • Hmm, maybe I should rephrase the question. If an NQSO is granted at $1, then exercised early, but after the FMV has increased to $2, then held for two years and sold at $5 - what is the breakdown of tax rates and taxable amounts?
    – ljwobker
    Jan 19, 2015 at 19:43
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    "early exercise" is meaningless from tax perspective, that's what I'm trying to tell you. Essentially, you end up with RSUs. You pay taxes on vest (unless 83(b) was timely filed) based on the FMV on vest. If you paid money during exercise that would be your basis. As simple as that.
    – littleadv
    Jan 19, 2015 at 19:47
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    It is, but only with 83(b) election. This is useful for startups in their early days when you want to ensure you don't end up with a huge ordinary income tax bill when they vest, but the FMV at early exercise is small enough for you to afford to lose it. But again - once you exercise it is no longer NQSO, it is RSU. I think that is what has confused you. 83(b) election is for RSUs, not for options.
    – littleadv
    Jan 19, 2015 at 19:58

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