To make sure we receive the full tax benefits to early exercise, we need a plan of action to make sure we are doing everything correctly. In order of importance, we need to prepare ourselves to make a decision, be able to pay for the shares and get our taxes straight with the IRS. Let's refer to our checklist below.
- Decide how much to early exercise
- Come up with enough cash to cover the total exercise cost
- File an 83(b) election with the IRS
Deciding on how much
Most startup employees make a decision on how much to early exercise based on the total cost required to exercise and their risk tolerance. To exercise our shares, we need to pay the company the total exercise cost or the total number of shares being exercised multiplied by the strike price of each share.
At this point, we can decide to early exercise all of our shares or just a portion of our shares.
Coming up with the cash
Cash should be set aside in a checking account that is easily accessible.
For those of us who also invest on the side, coming up with the cash to early exercise may require us to sell existing investments or assets. We also need to be prepared to set aside enough cash to cover any taxes.
The cash, if being transferred from another account should be fully settled and available.
Filing the right tax statements
The last and most crucial step is to file an 83(b) election with the IRS.
An 83(b) election is essentially what allows us to claim the tax benefits of early exercising. This very important form must be filed within 30-days of exercising! Failure to do so may mean that we're on the hook for taxes.
Two copies of the letter must be mailed to the IRS after they are filled out, printed, and signed. A pre-stamped return envelope must be included as well. Once the IRS receives the 83(b) and files it away, it will return one of the signed copies stamped with an acknowledgment and the date of receipt.
We can limit the risk of losing our total exercise cost while working at a very early stage company by early exercising a portion of our shares and waiting to exercise more as the company matures and hits milestones. The trade-off with partial early exercise is that we will end up paying more taxes in the future. However, that also generally means that the company is successful enough for us to sell our shares.
As we start planning to early exercise, we should be drafting an 83(b) election so that we don't forget and miss the deadline.