Hiring and scaling a team is essential to the success of any startup. You want a team that believes in your mission and can grow and guide the business to heights you never imagined. But to recruit and retain top talent is no easy task. Crafting a compelling equity package can help do this, especially if you are an early stage startup and money is tight.
While there are many considerations when outlining your startup equity compensation plans, you’ll need to determine whether to provide employees incentive stock options, nonqualified stock options, or restricted stock units. Here is a brief primer on the differences between them and what the tax implications are of each.
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Incentive Stock Options
ISOs can only be granted to employees and can qualify for preferential tax treatment. These are arguably the most common form of employee equity compensation in early stage startups. With ISOs, no taxes are required to be paid on the stock at the time of exercise and will only be taxed at the time they are sold (so when the company is either acquired or goes public).
If the stock is held for over a year before it is sold, it will then be taxed at capital gains instead of ordinary income rates, which is substantially lower. ISOs can, however, affect AMT (Alternative Minimum Tax). The difference or “spread” between the value of the shares at the time of exercise and the price paid will be considered as taxable income and can/will be used for adjusting AMT.
There are a few other things to note about ISOs:
- These options can’t be transferred (except at death),
- Options must be exercised within 10 years of the grant,
- Options must be exercised within three months of termination of employment (1-year extension for disability and no time limit for death), and
- An employee can only receive up to $100,000 worth of stock during a given calendar year based on the fair market value (at the time the option is granted) and anything past that will be considered nonqualified stock.
Nonqualified Stock Options
NSOs, also known as NQOs or NQSOs, in contrast can be granted to anyone, employees or not. The tax rules for NSOs are different than for ISOs in that you are to pay taxes at the time of exercise. What this means is that the difference between the value of the stock at exercise and the exercise price will be subject to regular income tax and employment tax rates.
When the stock is later sold, the gain or loss will be taxed at capital gains rate. Unlike ISOs, there are not AMT consequences and there are no restrictions on amount an employee, advisor, etc. can receive.
Restricted Stock Units
Lastly, there is restricted stock or restricted stock units (RSUs). These are similar to ISOs, but unlike ISOs, are given out all at once, typically when an employee joins the company and includes, as the name would suggest, restrictions. Restrictions usually include a vesting period and limits on returning/selling stock back to the company if an employee leaves before a certain period of time.
The advantage of restricted stock is that because employees are getting the stock earlier as opposed to waiting the full year and then exercising, capital gains will apply sooner. With restricted stock, it is important for all employees to file for an 83b which must be done within 30 days after the grant date of the restricted stock. For a full explanation of what an 83b election is, check out our Complete Guide to 83(b) Election for Startups.
If you’re still unclear, here are three super helpful diagrams (courtesy of The Venture Alley) outlining the important considerations for the three:
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