Using recourse notes to exercise options earlier and potentially start the QSBS clock sooner

For founders and employees of private companies, exercising stock options can create an obvious problem: the shares may be valuable, but exercising them can require significant cash.

One potential planning tool is a recourse promissory note issued to the company in payment of the option exercise price.

When properly structured, that can allow an individual to exercise options without immediately paying the entire exercise price in cash.

Why exercising earlier can matter

An option itself generally is not stock.

For federal tax holding-period purposes, property acquired through an option generally begins its holding period after the option is exercised.

That can become particularly important when the company may qualify as a qualified small business under Section 1202.

QSBS can potentially provide a significant exclusion from federal gain when all of the statutory requirements are satisfied, including the applicable stock holding period.

So for a founder or employee who expects the company to appreciate substantially, the timing of the option exercise can matter.

Where a recourse note comes in

Instead of paying the full exercise price in cash, an employee may issue a bona fide recourse note to the company.

The structure of the obligation matters. The note needs to represent real debt, not simply paperwork designed to make the exercise appear funded.

Terms such as repayment obligations, enforceability, collateral, interest, and the company's actual intent to collect can all matter.

Why this can matter for QSBS planning

Consider an employee with options in an early-stage C corporation.

If the employee waits several years to exercise, the QSBS holding period generally has not been running simply because the employee held the option.

An earlier bona fide exercise may allow the individual to acquire the actual shares sooner, which can potentially begin the relevant stock holding period sooner.

That does not mean every exercise creates QSBS. The corporation and stock must independently satisfy the requirements of Section 1202.

Other issues can also come into play, including:

• ISO versus nonqualified option treatment
• Section 83
• vesting restrictions
• potential 83(b) elections
• AMT
• valuation
• interest on the note
• enforceability and repayment terms

The takeaway

For the right company and the right shareholder, a recourse-note exercise can be worth evaluating well before a transaction or liquidity event is on the horizon.

The opportunity is not simply financing an option exercise. It may affect when the shareholder actually owns the stock and therefore when important tax holding periods can begin.