Can You Exercise a Stock Option With a Nonrecourse Note and Start Your QSBS Holding Period?
Founders and employees sometimes look for creative ways to exercise stock options early—especially when they are trying to start the QSBS five-year clock as soon as possible. One approach you’ll occasionally hear about is exercising an option using a promissory note instead of paying cash.
That raises a very real question:
If you use a nonrecourse note to exercise the option, does your QSBS holding period begin?
The answer is usually no. And the reason is simple: for QSBS purposes, you must actually own the stock. A nonrecourse note often means you don’t.
Let’s break down why.
1. QSBS Is All About When You Become the True Owner of Stock
Section 1202 only applies to the sale of qualified small business stock. That means you must receive stock from the corporation at original issuance. Options do not count, and promises to pay do not count.
Your QSBS holding period begins only when:
- You have acquired stock,
- At original issuance, and
- You have full beneficial ownership of that stock.
If any of those elements is missing, you have not started your QSBS clock.
2. Why Nonrecourse Notes Usually Fail to Transfer Ownership
When a person “pays” the exercise price using a nonrecourse promissory note, the company’s only remedy for nonpayment is to take back the shares. The individual has no personal liability and no financial risk.
The IRS has long viewed nonrecourse financing arrangements like this as incomplete stock purchases.
The key authority is Rev. Rul. 77-134, which held that where a purchase is funded by a nonrecourse note secured only by the stock itself, the buyer does not become the owner of the stock for federal tax purposes. Courts have echoed the same economic-substance reasoning.
Why? Because:
- The individual hasn’t really paid for the stock.
- The individual has no personal stake in the downside.
- The arrangement looks economically like an option to purchase, not an actual purchase.
If it walks and quacks like an option, the IRS may treat it like one.
And if it’s an option—not stock—you cannot have QSBS.
3. What About Recourse Notes? Those Can Work.
A recourse note is different. In a recourse arrangement, the individual is personally liable for the debt. If they don’t pay, the company can pursue them—not just the shares.
A recourse note is treated as valid consideration. In that case:
- The individual is treated as the genuine owner of the stock on the exercise date.
- The QSBS holding period can begin on that date (assuming all §1202 requirements are met).
Many early-stage companies use recourse notes for exactly this reason.
4. Why This Matters: QSBS Timing Is Everything
If your goal is to start the QSBS five-year clock, the type of note matters enormously:
- Nonrecourse note → likely no QSBS holding period start
- Recourse note → QSBS holding period can start (if the company qualifies)
And of course, the company itself must meet the gross-asset test at the time of exercise:
- $50M or less for stock issued before July 4, 2025
- $75M or less for stock issued on or after July 4, 2025
Exercising with a nonrecourse note after the threshold is crossed doesn’t help, because the stock may not be QSBS at all.
5. Early Exercises and 83(b) Elections Don’t Fix a Nonrecourse Note
Some people assume that if they early-exercise and file an 83(b) election, that cures any ownership issues.
It doesn’t.
Section 83 addresses how income is recognized. It does not determine whether a person actually owns stock for §1202 purposes.
If the IRS does not treat you as the true owner because your “purchase” was funded by a nonrecourse note, then:
- you don’t own stock yet,
- you don’t have QSBS, and
- your QSBS clock has not started.
6. The Practical Guidance
If the goal is to maximize QSBS eligibility:
- Avoid exercising with nonrecourse notes. They are too easily treated as incomplete purchases.
- Use cash or a recourse note. That creates real ownership and starts the QSBS clock.
- Make sure the company meets the asset threshold at exercise.
- Document the exercise cleanly. Clear stock issuance, consideration, and board approval.
If the economics matter more than QSBS, then the ideal structure may differ—but that requires a separate analysis.
Bottom Line
For QSBS, the law looks at substance over form. A nonrecourse note usually doesn’t transfer real ownership of stock, so it doesn’t start your QSBS holding period. If triggering QSBS is the goal, exercising with cash or a recourse note is the safer, cleaner path.
If you want, I can turn this into a multi-post series:
- early exercise mechanics,
- QSBS timing strategies for employees,
- post-July-4, 2025 planning,
- and how to handle option exercises when a company is approaching the $75M line.
