Filing taxes can be intimidating, but it’s as inevitable as death. Tax rules are complicated, subject to change, and frequently poorly written. Early-stage startup taxation is a relatively limited field and this is good news for founders. Four topics makeup about 60-80% of founder tax issues. In this two-part blog series, we will address common stock valuation and 83(b) elections.

Common Stock Valuation Issues 

Founders are usually aware of the valuation issues associated with preferred stock financings. The question of common stock valuation, however, is a different issue. Fair market value (FMV) is critical to understand. Issuing options with an exercise price at least equal to the FMV of the stock results in tax penalties. Failure to do so undermines the company’s equity compensation plan. Startup founders generally undertake these “409A” valuations every 12 months and immediately following each equity financing.

What Common Stock Options? 

Options are a right to purchase shares of a company at a set price (the “exercise price”). Companies typically grant options to those who provide services to the company. This includes employees, directors, and consultants, and are usually rights exercisable for the company’s common stock. Options allow a service provider to share in the growth of the company’s equity value. Options are also exercisable to an increasing number of shares. However, it must be over the period associated with the service provider’s service to the company. The purpose behind the structure of options is to encourage service providers to work harder for the company. It’s also to recognize additional value when the company experiences an exit event (e.g., a sale, merger, or similar).

Types of Options

There are two types of options: incentive stock options (“ISOs”) and nonqualified stock options (“NQSOs”). ISOs are granted to employees. While anyone is eligible for the NQSOs option, including non-employee service providers (e.g., advisory board members, consultants, etc.). 

Provided the requirements for qualification of an ISO are satisfied, employees are generally not taxed at the time of grant or exercise. This is true unless the alternative minimum tax applies. When you sell the stock underlying the ISO, gain, or loss (that is, the difference between the sale price and the exercise price) will be capital in nature. Similarly, NQSOs are not taxable to the service provider upon the grant (provided the company is not a public company). Still, upon exercise, the service provider will recognize ordinary income. This income is equal to the difference between the FMV of the shares and the exercise price.

ISO Requirements

Aside from the FMV issue discussed below, ISOs are subject to several requirements, including the following:

• ISOs must be granted under an option plan. This plan needs to adopted by the company’s board of directors and approved by the company’s stockholders.
• ISOs are subject to a $100,000 vesting limit per year per recipient; anything over the limit is an NQSO.
• Stockholders that hold 10% of the company’s voting power aren’t eligible for the ISO option.

Subject to the FMV discussion below, NQSOs are not subject to these requirements.

The Importance of Exercise Price

The option exercise price cannot be less than the FMV of the underlying stock at the time of grant. This applies to both ISOs and NQSOs.

Options with an exercise price under FMV become NQSOs. NQSOs with an exercise price under FMV requires special attention. These are subject to the penalty provision of Section 409A of the Internal Revenue Code of 1986, as amended. Under this penalty provision, the service provider who receives the options will face immediate taxation on each vesting event. In addition, they will receive a 20% penalty. The company will have certain withholding obligations. As a result of the penalties, its equity compensation plan will be undermined. Similar state tax penalty provisions may apply as well.

Introduction to 409 Valuations

To avoid these 409A penalties, a non-publicly traded company should undergo regular “409A valuations.” These valuations must involve the “reasonable application of a reasonable valuation method.” Depending on your company’s stage of growth, a full third-party valuation may not always be necessary. Still, the company’s valuation must be made per the code and applicable Treasury regulations requirements. The company should consult its legal counsel and financial advisors before proceeding. 

Read Part II of our “Startup Tax Issues” series. We breakdown 409A valuations further and provide more tips for avoiding penalties. Click here to read now. 

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