The Tax Impact of Stock Options On Startup Companies

Business Tax

The Tax Impact of Stock Options On Startup Companies

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Incentive stock options are a great form of compensation for start-up and emerging companies. Many times, start-up companies may not have cash on hand in order to finance the company operations and provide a competitive pay base to important employees.

Through the use of stock options startup companies can provide incentive and motivation to both employees and nonemployees without an immediate cash outlay. It is important for startup companies to fully understand the income tax consequences of stock options in order to maximize the after-tax value of both the company and the individual granted the options.

By definition, stock options are a contract that gives the holder the right, but not the obligation, to purchase a certain number of company shares at a predetermined price after a specified period of time. The employee must meet the vesting period in order to buy or sell the stock options. Typically, the exercise price is the market value of the shares when the options are granted and the vesting period ranges from two to four years. The tax Code segregates stock options into two distinct categories: incentive stock options and nonqualified stock options

Incentive stock options, commonly referred to as ISOs are a type of option that meets certain requirements set forth under IRC 422(b). These requirements include limitations around company management specifications, holding periods and valuations, and most importantly a specified number of options issued. If the options meet the definition and requirements of an ISO, the purchase and subsequent disposition of the stock generally qualifies for capital gain treatment under IRC 421. The employee should be mindful of circumstances that would trigger ordinary income rather than capital gain treatment such as a specified holding period before sale.

Conversely, nonqualified options commonly referred to as NQs or NQSOs do not meet the requirements set forth under IRC 421. These options can be granted in unlimited amounts to the recipients, which can include both employees and nonemployees. Unlike ISOs, the exercise of a nonqualified option gives way to ordinary income rather than capital gain treatment for the taxpayer.

The Classification of the Options Decides the Tax Impact

To analyze the impact of stock options we must look at the impact to both the issuing company and the employee receiving the options. In some cases, the individual receiving the options recognizes a favorable tax situation and in other instances the company is on the favorable side of the transaction.

Incentive Stock Options (ISOs) generally do not result in a taxable event until the employee sells the stock. The sale causes a favorable tax impact for the individual but not the issuing company. The company issuing the stock options is not allowed a tax deduction for ISOs that are issued and exercised (except for in certain cases when the options do not meet specified requirements). On the other hand, the employee receiving the ISOs will recognize favorable tax treatment if they meet all requirements set forth under IRC 422. The taxpayer will be able to exercise these options at a future time and the income will be characterized as capital gains/losses rather than ordinary income. As a result, through careful planning, the individual exercising the ISO will pay tax on the exercised options at a tax rate of 20%.

Nonqualified Stock Options are more tax-friendly to the company issuing the stock. In this situation, the company issuing the options is allowed a tax deduction at some future point in time when the options are exercised. Conversely, the employee in this case will recognize ordinary income equal to the intrinsic value of the stock when the options are exercised. The intrinsic value will be determined as the difference between the grant price (i.e. purchase price) and fair market value of the stock on the date of exercise. This gain reported on the stock option exercise is taxed at ordinary income rates rather than capital gain rates. Ordinary income rates for an individual taxpayer can reach as high as 39.6%

Withum-placeholder Tyler Tedesco
973-898-9494
[email protected]

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The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals.

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