published January 27, 2021
Early-stage startups often use stock options to compensate employees and align the two parties’ interests. Further complicating the dance of employee equity compensation is the fact that there are not one, but two forms of stock options used by most startup companies: ISOs and NSOs.
ISOs can only be granted to employees, while NSOs can be granted to consultants, advisors, and directors as well as employees. If NSOs work for both, then why do most early stage companies grant their employees equity options in the form of ISOs instead of NSOs? The answer: ISOs have special tax advantages.
Non-Qualified Stock Options (NSOs, Sometimes NSQOs)
NSOs are the simpler of these two forms of stock options. They may include a vesting schedule or may not. Taxation on NSO’s first occurs when they are exercised and is based on the spread between the fair market value (FMV) of the stock at the time of purchase and the strike price of such options, which is usually zero but not always.
The amount between the strike price and FMV is treated as ordinary income tax, not capital gains.
To qualify for long-term capital gains treatment on the sale of stock purchased through an NSO the sale must be both: (1) held for one year after purchase and (2) from options granted at least two years prior to the sale. Stock held for less than one year or less than two years after grant date will be subject to typically higher ordinary income treatment.
It is not possible to file an 83 (b) election for NSOs (hence their designation as “non-qualified”). As an interesting side note, because the exercise of NSOs is considered compensation, they are tax deductible for the issuing corporation, but we won’t get into this now.
Qualified Incentive Stock Options (ISOs)
Incentive stock options may only be offered to employees and expire 10 years after their issue. At most companies, they typically expire 90 days after employment is terminated, though there are some companies who allow a longer window.
They almost always come with a vesting schedule, and many companies will offer early exercise when they are unvested in an attempt to maximize employee gain and minimize taxes.
One of the qualifications for an ISO is that it must be equal to the FMV at the date of the grant. There are no income tax liabilities incurred for holders of ISOs at the time of exercise, but AMT (Alternative Minimum Tax) must be paid in that tax year on the amount that the FMV exceeds the option price at the time of the grant.
This is unlikely, but could occur in a scenario where they were granted at a certain price by the company and a new 409a valuation was completed between their grant/purchase and exercise.
Like NSOs, ISO stock is taxable at the long-term capital gains rate if: the stock is held for at least one year after exercise and the option grant date is over two years prior to the sale. In the case that early exercise is allowed, ISOs are eligible for the 83 (b) election, which allows you to avoid their taxation as income and also starts the clock on their consideration as capital gains.
You must file the 83 (b) election within 30 days! There are NO exceptions. Learn more about how to do that in the article Why You Should File Your 83 (b) Election.
Watch out for AMT liability. In the case that you don’t early exercise your ISOs, you could be taxed at when they vest at the AMT rate, which can present a rather hefty tax burden.
Years ago, as the first engineer hired at a growing startup, I purchased a significant number of my shares after they had already vested when I was leaving the company—my tax bill ended up being over $60k and I had to get a payment plan from the IRS in order to pay off my tax liability.
They are mostly covered above, but it pays to know the phrase “disqualifying disposition”. One of these can only occur if you’ve filed the section 83b election (thus the name). If you sell before 2 years after the grant date, you will have a disqualifying disposition on your hands, and will not be eligible for long term capital gains taxes.
Regardless of the time of grant, a year must also have passed since your 83b election date, or you will have another case of a disqualifying disposition, and a higher tax burden will result. Barring any unforeseen circumstances, they are easy
- NSOs (Non-qualified Stock Options) can be used to compensate employees, consultants, directors, business partners, and advisors.
- ISOs (Incentive Stock Options) can only be used to compensate employees.
- NSOs are taxed as regular income at the time of exercise and are not eligible for an IRS section 83b election.
- ISOs have no tax liability at the time of exercise you take an IRS 83b election.
- ISOs and NSOs will be taxed at the capital gains tax rate if they are held for a minimum of 2 years after the date of exercise.
- Certain disqualifying dispositions can result in a higher tax burden.
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A detailed overview of the different types of equity compensations for employees at startups, including restricted shares awards, stock options and RSUs. Each type of equity award has different tax implications for employee shareholders at startups.