Are Stock Options Right for Your Startup Company?
Since the early days of Silicon Valley, startup technology companies have relied on stock options to lure new talent. The strategy has proven successful, but there are many considerations that tech companies should keep in mind when pursuing this type of equity incentive. It is essential to understand not only the different kinds of stock options available but also the related tax implications and the potential pitfalls for both employers and employees.
Choosing the Right Type of Stock Option
There are two primary types of stock options available to tech companies looking to provide equity incentives: Incentive Stock Options and Non-qualified Stock Options. Both have various pros and cons, especially as they relate to tax implications, that can help you determine which is best for your company.
Incentive Stock Options (ISOs)
- These stock options are designed to comply with provisions of the Internal Revenue Code. Your employees do not have to pay income tax on the issuance or the exercise, but rather only when they sell the stock in the future.
- While employees who exercise an ISO don’t have to report regular income on their tax returns, they do have to report alternative minimum taxable income for the difference between the fair market value and the exercise price. This additional alternative minimum tax creates an alternative minimum tax basis in the stock, thus reducing the amount of alternative minimum tax to pay on the disposition. Furthermore, as opposed to non-qualified stock options, ISOs are not subject to FICA taxes.
- As long as the stock exercised is held 1 year from the date of exercise, it will qualify for long-term capital gain treatment.
- However, ISOs carry some strict holding requirements. Stock must be held for 2 years from the date of the grant and 1 year from the date of exercise. ISOs will lose any favorable tax benefits if employees do not meet these holding period requirements. This event is known as a “disqualifying disposition.” These dispositions are commonplace, as many employees exercise their ISOs just before the sale of the company. This treatment essentially throws the option into the “Non-qualified” bucket, which we dive into next…
Non-qualified Stock Options (NSO)
- Simply put, these stock options do not comply with ISO provisions of the Internal Revenue Code, which means they do not qualify for the same beneficial tax treatment available for ISOs.
- When an employee exercises a Non-qualified Stock Option, he or she must recognize income from the exercise, which is calculated as the difference between the fair market value and the strike price. This income will be reported on the employee’s W-2 and is therefore subject to Federal, State, and FICA taxes.
- However, this income is considered phantom income because the employee is reporting income but is not receiving any cash. The employer is responsible for submitting employee taxes on the amount, even though there is no cash payment from which to withhold the taxes. In some scenarios, employers will ask the employee to submit payment to the company to cover the cost. Otherwise, the employer may withhold a portion of the exercised stock to cover the employee’s taxes. In order to complete the exercise, most stock option plans require the employee to fund not only the exercise price but the tax withholding amount too.
- Like ISOs, if the employee holds the stock for one year from the date of exercise, the sale will qualify for long-term capital gain treatment.
- The employee’s basis in these shares will be the exercise price, plus the phantom income triggered on the exercise date.
Understanding Reporting Obligations for Stock Option Exercises
Regardless of which stock option you choose for your employees, both ISOs and NSOs carry reporting obligations for exercises.
For ISOs, companies must file Form 3921 with the IRS to report the fair market value, strike price, date of exercise, and shares transferred to the employee.
For NSO options, the exercise is reported to employees on their W-2. Or, if the NSO option is exercised by a nonemployee, this should be reported on Form 1099-NEC as nonemployee compensation.
Evaluating Other Tax Considerations
If your tech company or startup is looking to offer stock options, you need to be knowledgeable about the reporting and tax obligations both for the company and for employees receiving the incentives, especially those outlined in IRC Sec 409A.
Understanding IRC Section 409A is critical for companies offering stock incentives. 409A governs deferred compensation plans and provides strict guidelines on how companies value their stock options and/or stock grants.
Any stock option with an exercise price less than the fair market value at the date of the grant are subject to 409A rules, which can have dire consequences for the employees, including the requirement to recognize the entire amount of the option in income while also incurring a 20% excise tax penalty.
If you’re offering stock options as an equity incentive, you should have a valuation performed to ensure your stock option grants are not in violation of Section 409A.
Aprio can help you complete your 409A valuation, as well as guide you to the proper stock option plan structure and determine how to manage the granting, issuance, and exercises.
The Bottom Line
If you’re a tech company or a startup looking to offer equity incentives for your employees, it is crucial to understand the alternatives at your disposal and the associated risks. You don’t have to make these decisions alone. Working with a knowledgeable tax advisor can help you identify the most advantageous alternatives for your company and your employees, while also ensuring you remain in full compliance with all applicable tax rules.
For more information about equity incentives and the related steps, like 409A valuations, contact Ori Epstein.