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Taxation Stock Options Part II
by Peter Soh, CPA

You can receive services and products with very little cash outflow. Many startups are initially undercapitalized until they receive the big boost from investors like angels or venture capital firms.

You will need to consider the following:

1. Which type of stock option?
2. What are the tax consequences for the company and the employee for each type of stock option plan?

Non-qualifying Stock Options (NSO's)
NSO' are not specifically defined by the IRS but must have a written plan stating the option price, number of shares, the employee, the exercise period, and the grant date. NSO's are taxable as compensation to the employee when the stock has a readily ascertainable fair market value and all substantial restrictions lapse. NSO's can be taxable on the grant date but this situation is unusual since must startups do not have a readily ascertainable value on their stock until "going public". Typically, the employee will exercise after the stock goes public, and the exercise date will be the date, in which he must incur the compensation income (FMV of the stock-option price). If substantial restrictions exist like a vesting schedule, then the employee can defer the income until those restrictions lapse. At the time the employee recognizes compensation income, the employer reciprocally can deduct that amount as salaries expense. If the employee sells the stock after 1 year from the time the income is taxable then he can receive favorable capital gains treatment for the remaining appreciation in the stock at a 20% tax rate.

The employee can choose an 83b election to accelerate compensation income at the exercise date. The employee will be taxed on the spread on that date on ordinary income rates up to 39.6% but any remaining appreciation will be potentially taxed at 20% if the employee holds the stock for over 1 year.

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