What’s Better For An Equity Incentive–Restricted Stock or A Stock Option?

stocksEarly stage companies frequently want to bring on key hires and incentivize them with equity, but do not know what type of equity award is the best from a tax perspective to both the employee and the company.  There are in general two types of equity awards most commonly used (assuming that the company is operating in the corporate form and not as a limited liability company):

  • stock options; and
  • stock awards or stock grants.

In general, for a private company with limited cash reserves, and whose key hires also desire to preserve their cash (and not pay it to the IRS), stock options are usually going to be a preferable alternative to stock grants (unless the current value of the stock is so low that the immediate tax impact is nominal).

The reason?  Stock grants will be taxable either (1) upon grant, if fully vested, or if a Section 83(b) election is made (in which case the taxes must be paid immediately upon grant, and will have to be withheld from the employee–i.e., the employee will have to write a check to the company for the taxes), or (2) upon vesting, when the value may be considerably higher than the value on the date of grant (and the taxes must then be paid at that time, and the employee will have to write a check to the company at that time for the taxes).

The primary benefit of a stock option as opposed to a stock grant is that if the stock option is priced at fair market value on the date of grant, the receipt of the option is not taxable to the optionee, and the option will not be taxable at all until exercise–the timing of which the optionee controls (as opposed to a vesting date for a restricted stock award).

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About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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  • http://biznik.com Lara Feltin

    Thanks for spelling this out so clearly, Joe.

    Question about the stock option: You said, “the option will not be taxable at all until exercise.” At the time of exercise, is the tax calculated from the value set on the date of the grant, or from the value of the stock on the date of the exercise?

    • http://startuplawblog.com/joewallin Joe Wallin

      Lara, at the time of exercise, the tax will be calculated based on the then value of the shares received on the exercise of the options. So, if the value of the shares underlying the option goes up dramatically from the date of grant to the date of exercise, the tax impact will go up as well. For a nonqualified stock option, the spread is ordinary income, subject to income and employment tax withholding. For an incentive stock option, the spread is not subject to income or employment tax withholding, but the spread is an alternative minimum tax adjustment which the employer must report to both the employee and the IRS.

  • http://twitter.com/chrisamccoy Chris McCoy

    thanks for helping us with this one Joe!