Exercise ISOs/NSOs Prior to a QSBS Disqualifying Event
If you own options in a company about to disqualify for QSBS, exercising your options before this event allows the purchased shares to qualify for preferential QSBS treatment.
Strategy Overview
If a stock qualifies as QSBS, the owner can potentially exclude up to 100% of their capital gains from taxes when the stock is sold. One important criteria of QSBS qualification is that they company cannot have ever had gross assets that exceed $50 million prior to investing.
If you own ISOs or NSOs in a company that is about to cross this $50 million threshold, a strategy to consider is exercising your options before the threshold is crossed, preserving the potential for the QSBS tax exclusion.
Tax Details
Stock sales that qualify for the QSBS tax exclusion can avoid paying taxes as high as 34% on the sale (up to a gain of $10 million; potentially more when using stacking strategies). There are a number of QSBS criteria that need to be met to qualify, so careful planning is required.
One criteria of particular importance to ensuring QSBS qualification: the purchase of QSBS stock needs to occur prior to the company having gross assets exceeding $50 million. With VC-backed companies, this before/after threshold is most commonly crossed due to a VC raise in excess of $50 million.
If you have stock options in a company that are either (i) vested, or (ii) allow for early exercise via 83(b), and a VC raise in excess of $50 million is anticipated, you have a strategic choice to make:
Exercise prior to the VC raise when the resulting purchase of shares would still qualify for QSBS.
Don't exercise prior to the VC raise, accepting that any exercise in the future will not qualify for the QSBS tax exclusion.
Key Benefits
Maintain potential qualification for the QSBS tax exclusion. By exercising your options before the company surpasses the $50M asset threshold, the shares you purchase (assuming all other QSBS criteria are met) should maintain their prospective QSBS eligibility. If held for the required 5 years thereafter prior to sale, the gains (if applicable) should qualify for the QSBS tax exclusion.
Key Considerations/Flags
Company must meet other QSBS rRequirements. There are a number of QSBS criteria, and you must meet every single requirement to be eligible for the QSBS tax exclusion. If your investment in your company would not meet any of the other criteria, then this strategy is not applicable.
You will need to hold the stock for at least 5 years after exercise. One of the qualifications for the QSBS tax exclusion is holding the stock for at least five years. If you anticipate selling the stock prior to 5 years, this strategy is unlikely to apply.
Requires capital to exercise options. Exercising options requires you to pay the exercise price up front, and if applicable, income taxes on NSO exercises or AMT on ISO exercises. You should ensure you have the necessary capital and are comfortable with the risk before exercising your options.
Strategy: When to Consider This and When to Avoid It
The company clearly meets other QSBS requirements. If your company clearly meets other QSBS requirements, exercising options prior to a QSBS disqualifying event will allow you to maintain prospective qualification for the QSBS tax exclusion (pending the 5 year hold requirement).
You can hold the shares for 5+ years. To qualify for the QSBS tax exclusion, you must hold the stock for at least five years. If you sell prior, it won't qualify for the exclusion.
You have the available capital and are comfortable with the investment risk. Exercising options requires you to pay the exercise price up front, as well as any associated income or AMT taxes.
The company operates in a disqualified industry. There is no benefit to exercising ISOs/NSOs for QSBS treatment if the company operates in a disqualified industry or has too many shareholders, both of which would prevent qualification for the QSBS tax exclusion.
Limited capital to exercise options. Exercising options requires you to pay the exercise price up front, as well as any associated income or AMT taxes. If you don't have the funds, or are uncomfortable with the investment risk, this strategy is unlikely to be the best for you.
Example
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