One of the most complex and contentious issues that a startup company grapples with is the equity compensation for its employees. Selecting the right equity compensation arrangement for the employees of a growing startup is a task that requires thoughtful consideration and legal knowledge. This article will outline the main types of equity compensation awards used by startup companies, including a discussion of the federal tax consequences and how the growth phase of a startup factors into the equity awards decision.

Restricted Stock

Restricted stock is subject to restrictions on its transfer and resale. If the employee is terminated, the company generally has the right to repurchase the restricted stock for a certain period of time after the termination.

Employees who are granted restricted stock as compensation are subject to Section 83 of the Internal Revenue Code. Under Section 83, the employee is taxed in the year the restricted stock vests. If the employee files a Section 83(b) election form, the employee can elect within 30 days of receiving the restricted stock to be taxed on the date the equity was granted rather than the date which the equity vests. However, in the year that the restricted stock vests, the employee still must report the amount the fair market value (FMV) of the stock on the vesting date exceeds the amount paid on the equity grant date.

Stock Options

Stock options entitle the holder to purchase a designated number of shares of the company’s stock at a fixed exercise price at the end of a certain vesting period.

A non-qualified stock option is a type of stock option granted for the performance of services. Similar to restricted stock, non-qualified stock options are subject to Section 83 of the Internal Revenue Code. The person pays ordinary income tax on the difference between the grant date price and the price on the exercise date.

An incentive stock option (ISO) is a special type of stock option that enables a company’s employees to pay lower taxes if they meet certain holding period requirements. If the stock that is purchased is held for more than one year after the exercise date and for more than two years after the grant date, the sale is subject to the long-term capital gains tax rate, rather than the higher ordinary income tax rate.

ISOs may only be granted to employees, whereas non-qualified stock options may also be granted to non-employee directors and independent contractors.

In order to be exempt from Section 409A of the Internal Revenue Code, stock options must be granted with an exercise price that exceeds the fair market value of the stock on the grant date. Section 409A imposes high taxes on stock options with below-FMV exercise prices.

Restricted Stock Units (RSUs)

A restricted stock unit (RSU) is an award of shares after the satisfaction of specified vesting period. Upon vesting, the holder of RSUs is entitled to receive a specified number of shares of common stock or a cash amount equivalent to the value of a specific number of shares. If the vesting requirements are not satisfied, the RSUs are forfeited. Ordinary income tax rates are typically applied to RSUs upon settlement, assuming that the RSUs comply with Section 409A of the Internal Revenue Code.

Since startup companies often rely on equity compensation packages as a way to attract and retain talented employees, choosing the right mix of equity awards can be essential. Equity compensation is highly complex, and involves a number of tax considerations. Startups should work with their legal and accounting advisors to select the right equity compensation mix that is appropriate for their company’s growth stage and other unique circumstances.