Employee Stock Options and Their Tax Impact on Startups

What Are Startup Stock Options?

Startup stock options give employees the right to purchase company shares at a predetermined price, known as the “strike” or “exercise” price. Employees can profit from startup stock options if the company’s stock value exceeds that specified price. Typically, options vest over time, meaning employees earn the right to purchase shares incrementally. This vesting schedule encourages long-term commitment to the company by requiring employees to stay with the business for a set period before they can exercise their rights. Here’s a vesting breakdown:

• Grant phase—the employee receives the stock options as part of their compensation.
• Vesting phase—over time, employees earn the right to exercise some of their options.
• Exercise phase—employees can buy shares at the exercise price once vested.
• Exit phase—employees can sell their shares if the company goes public or another company acquires it.

Owning startup stock options can be life-changing—but only if the company succeeds and employees navigate the tax implications carefully.

Are Startup Stock Options for Employees Worth Anything?

The short answer is it depends. Stock option value depends entirely on company growth and success. If the startup’s value increases, your stock options could be profitable. However, if it struggles or fails, options may become worthless. For this reason, employees should consider stock options a high-risk, high-reward part of their compensation.

Are Startup Stock Options Taxable?

Stock options are taxable. However, taxation depends on the stock options and when you exercise them. When are stock options taxed? How are stock options taxed? By asking these questions and knowing about associated tax rules, you can learn how to minimize taxes on stock options and make informed decisions.

What Are the Different Kinds of Startup Stock Options for Employees?

The following are the primary stock options for employees.

Incentive Stock Options (ISOs)

ISOs are generally tax-favored, meaning you don’t pay ordinary income tax during the exercise phase. However, you may need to pay the Alternative Minimum Tax (AMT), and you’ll face capital gains tax when you sell the shares if they increase in value. You may also face ordinary income tax if you don’t satisfy the holding period requirements.

Non-Qualified Stock Options (NSOs)

NSOs are more common and taxed when the options are exercised. You must pay ordinary income tax on the difference between the exercise price and the market value when you exercise your options.

How Are Stock Options Taxed?

ISOs

ISO holders don’t typically owe regular income tax when exercised, but the AMT may come into play. If you sell the shares and meet the holding period requirements, you’ll be subject to capital gains tax rather than ordinary income tax, which means a lower rate.

NSOs

NSO holders pay ordinary income tax during the exercise phase based on the difference between the exercise price and the stock’s fair market value (FMV). Depending on how long you’ve held the shares, gains from share sales may be subject to capital gains tax.

When Are Stock Options Taxed?

Generally, startup stock option taxes trigger at two stages:

• At the time of exercise. With NSOs, the IRS treats the spread—i.e., the difference between the FMV and the exercise price—as ordinary income. For ISOs, this spread isn’t taxed immediately but may factor into the AMT.
• At the time of sale. When employees sell their shares, they may face either short-term or long-term capital gains tax, depending on how long they’ve held the shares.

Understanding the difference between short-term and long-term capital gains taxes is also essential for understanding when it might be best to sell.

How Can I Minimize Taxes on Stock Options?

There are several strategies you can use to reduce your tax burden:

• Early exercise. Exercising options early in their life can reduce the spread between the strike price and market value, lowering taxable income.
• IRC Section 83(b) Election. This IRS provision allows you to elect to pay taxes on the spread at the time of exercise. If the stock’s value is low early on, it will reduce your tax burden, particularly if shares are expected to grow significantly.
• AMT planning. Understanding and planning for the Alternative Minimum Tax can prevent unexpected tax burdens when exercising ISOs.
• Holding periods. For ISOs, adhering to the holding periods ensures you benefit from long-term capital gains tax rates.
• Plan around life events. To help reduce your tax bracket, strategically exercise options around periods when your income may be lower. Or, you could consider waiting until you have other offsets, like business losses.

These strategies don’t always apply in every instance. Make sure to consult a financial planner or tax expert to explore which strategy best fits your situation. Consulting with a tax advisor who can help you structure exercises and sales to optimize tax outcomes is vital to getting the most out of your stock options.

What Happens to Stock Options When a Startup Is Acquired?

Here are a few common scenarios that might play out:

• Full vesting—in some cases, an acquisition accelerates vesting of stock options, meaning employees can exercise all their options and cash out.
• Cash buyout—depending on the acquisition terms, employees may receive a cash payout for their stock options.
• Conversion—the acquiring company may convert the stock options into equivalent options or shares in the new company.
• Cancellation—in some cases, companies may cancel underwater options (where the exercise price exceeds the FMV).

Employees should closely review the acquisition agreement and consult with legal or financial advisors to understand their possible choices.

Conclusion

Employee stock options offer a unique opportunity to share in a startup’s success. By asking questions and understanding how stock options work, owners and employees can navigate this landscape confidently. Whether you’re a founder intent on developing enticing compensation packages, an employee evaluating your options, or an investor assessing potential rewards, understanding startup stock options for employees and their tax impacts will help you make thoughtful, strategic decisions.

Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.