Types of Options
There are only two types of options that you will get at a startup — an Incentive Stock Options (ISO) or a Nonqualified Stock Options (NSO). In IRS speak, an ISO is called a Statutory option while an NSO is called a Nonstatutory option.
Incentive Stock Options
These type of options can only be issued to employees. They have certain tax advantages, the biggest being that ISOs are taxed on the sale of the stock not the exercise of the option. This means that you can exercise your options and not have to worry about taxes until you actually sell the stock. Well, not exactly. You do need to look into Alternative Minimum Tax (AMT) triggers since that plays by a different set of rules (see below). Some of the other rules that ISO’s follow are:
Must be granted at Fair Market Value (FMV)
Must be granted 10-years after board approval
Must be exercised 10-years after the grant date.
Nonqualified Stock Options
All other options, at a startup, are typically NSOs. There are something called warrant’s, but those are usually reserved for outside investors, so we won’t deal with that here. NSOs are more flexible than ISOs but they don’t have the same tax advantages. The main thing about NSOs is that they are taxed when you exercise the option. This means they are taxed at ordinary income tax levels and you don’t get the benefit of long term capital gains. NSOs have the flexibility in terms of:
It is critical that you understand which type of options you have. The tax implications are real and severe if you do the wrong thing. It’s best to consult a professional tax advisor as to your best course of action.