Incentive stock options and non-statutory stock options
March 5, By Yokum 19 Comments. No regular federal income tax is recognized upon exercise of an ISO, while ordinary income is recognized upon exercise of an NSO based on the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. NSO exercises by employees are subject to tax withholding.
However, alternative minimum tax may apply to the exercise of an ISO. If shares acquired upon exercise of an ISO are held for more than one year after the date of exercise of the ISO and more than two years after the date of grant of the ISO, any gain or loss on sale or other disposition will be long-term capital gain or loss. A company may generally take a deduction for the compensation deemed paid upon exercise of an NSO.
Similarly, to the extent that the employee realizes ordinary income in connection with a disqualifying disposition of shares received upon exercise of an ISO, the company may take a corresponding deduction for compensation deemed paid.
If an optionee holds an ISO for the full statutory holding period, the company will not then be entitled to any tax deduction. None, but an NSO granted with an option price less than the fair market value of the stock at the time of grant will be subject to taxation on vesting and penalty taxes under Section A. Employees only Anyone How Taxed for Employee: Gain or loss is the difference between the amount realized from the sale and the tax basis i.
One addition for ISO taxes: When ISO exercise triggers AMT, tax credit available for use in future tax years, and when the ISO stock is sold, another very complex AMT adjustment.
You might want to see the ISO or NQSO sections on http: Hi Yokum We need to issue equity warrants in lieu of cash for both contractors, landlords, and employees of our startup. However, we also would like to minimize the personal income tax liability to the individuals as it is really the intention of the warrant to pay them in stock which they would only owe captial gains tax on sometime in the future.
Should these warrants be structured as stock grants or stock options to be converted to common stock at series A funding? Typically, most companies would issue an option to purchase common stock to these people at a low exercise price equal to fair market value.
Keep in mind that a stock grant i. Options may be fully-vested in the case of landlord, or subject to a vesting schedule in the case of service providers.
Options and warrants mechanically work the same way in that they are a right to purchase stock in the future. They are called options when they are compensatory. A warrant to purchase yet to be issued Series A stock at the Series A price is somewhat odd, unless bundled in connection with a convertible note or as a kicker on debt.
At the time this warrant is issued, the value of the warrant strikes me as income. If the person is an employee, it seems like there are also some A issues because this may be deemed deferred compensation. I am starting a company that today is nothing more than an idea.
I have taken no funding and have no product or revenue yet. I will likely raise a small round of angel funding once I have a proof of concept.
I now have the agreement of someone to help me in an advisory capacity create that proof of concept and I will grant him an NSO as compensation. See rationale in comment above. The company is private and an s-corp foreign ownership is not possible so the SARS are not vesting into options. If he cannot excercise, will the company keep the SARS until a liquidity event occurs? Does he have to follow the regular exercise schedule? What happens if the company converts into a C-corp in the next future?
Will his SARS automatically convert to options? McGregory — I assume that you are talking about stock appreciation rights, as opposed the virus. Virtually no silicon valley venture-backed startups use SARs instead of stock options, so it is difficult to speak in generalities as to how SARs work. Basically, you have to read the SAR document carefully. We have a non qualified stock option plan for an LLC. Vesting and exercise was to occur at a liquidation event such as an acquisition or sale, which we thought might occur within a year, to alleviate the possibility of low level employees vesting and exercising options and becoming a member of the LLC and accompanying tax issues — K-1's etc.
As our time horizon is growing, we wanted to include a 3 year vesting period. Question is, upon vesting, would our employees face a taxable event. We did have a valuation done, and the exericise price was set above the value at grant date to avoid any a issues. Please ask your own lawyers who set up the option plan and the operating agreement.
I'm not quite clear on that response.
You seem to be saying that warrants would never be used to compensate contractors, but rather NSOs? As a contractor considering receiving a percentage of my compensation as equity, I'm confused about the idea of receiving options in lieu of cash.
It seems to me that I should be granted stock in exchange for cash I don't receive, not the option to buy stock. I understand that an option to buy later at today's price has some value, but that value is not necessarily related to the current price. It seems like the original poster above was indeed trying to figure out how to compensate contractors with stock.
In your response section 5, are you suggesting a stock grant?
And that couldn't be done until the Series A, and would be treated as taxable income? I think I've learned enough now to answer my own question: The stock would have to double in value to provide the intended compensation. Stock grants are no good, either, because they will have large tax consequences.
Of course, thanks to the ridiculous IRS position of them wanting taxes before the stock is actually sold!! Hi Yokum, This is a great forum with full of useful info. We're forming a C type company. A person who has been contributing since the pre-incorporation days wants to invest in the equity just like other co-founders and then be a consultant.
Incentive Stock Options vs. Nonqualified Stock Options | Startup Law Blog
He is not an accredited investor. We need him but he doesn't want to be an employee or board member. Is it possible for the company to go with him? Will the stocks given to him all be NSO? Thank you very much — Raghavan. Raghavan — I would just issue and sell common stock to him at the same price as other founders. Please keep in mind that if he has a day job, there may be limitations on his ability to purchase stock.
Is there any way you could expand on your comment 'if he has a day job, there may be limitations on his ability to purchase stock'? Can NSO be assigned to a non-employee who may be an advisor to the start up but may have a full time job elsewhere? Raghavan — see this post http: Hi Yokum — is there any scenario in which a company can extend the day exercise period for ISOs for a departing employee?
Tax Topics - Topic Stock Options
Can the nature of the relationship with the employee be changed to an advisor and thereby not trigger the exercise period? Rahul — Typically, an option agreement has language that says that the option must be exercised within X days i.
Service provider is broad enough to encompass employees, directors, consultants, advisors, etc. Thus, an employee can move to contractor status and the option typically continues to vest and does not need to be exercised.
How Incentive Stock Options are Taxed
However, the ISO will turn into an NSO if the employee is no longer an employee after 90 days. Index About Yokum Disclaimer Privacy Policy Contact Yokum FAQs. Below is a table summarizing the principal differences between an ISO and an NSO.
Please help clarify the typical equity warrant issued pre-series A financing in lieu of cash. Hi Yokum, I am starting a company that today is nothing more than an idea. Hey Yokum — this is a great post! Please consider the following scenario:
