What you pay will depend on what kind of options you have and how long you wait between exercising and selling. With NQSOs, the federal government taxes them as regular income. The company granting you the stock will report your income on your W The amount of income reported will depend on the bargain element also called the compensation element. When you decide to sell your shares, you will have to pay taxes based on how long you held them. If you exercise options and then sell the shares within one year of the exercise date, you will report the transaction as a short-term capital gain.

This type of capital gain is subject to the regular federal income tax rates. If you sell your shares after one year of exercise, the sale falls under the category of long-term capital gains.

Part 1: Startup stock options 101

The taxes on long-term capital gains are lower than the regular rates, which means you could save money on taxes by holding your shares for at least one year. ISOs operate a bit differently. You do not pay taxes when you exercise ISOs, though the amount of the bargain element may trigger the alternative minimum tax AMT , which phases out income exemptions targeted for low- and middle-income taxpayers.

When you sell shares from ISO options, you will need to pay taxes on that sale. If you sell the shares as soon as you exercise them, the bargain element is treated as regular income. Stock options are becoming a more common way for companies to attract and keep employees. Option terms are set by the individual company through a contract you must sign.

You should familiarize yourself with the terms in that contract. It will tell you how many options the company is granting and the length of the vesting period. The contract will also have the grant price, which is what you will pay when you exercise those options.

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How and when you exercise options will depend on the price of the shares. There are also income tax considerations, with the promise of lower tax rates if you hold onto your shares for at least one year.

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Taxed as regular income. Managing the plan efficiently — Once a company has established the plan with the help of their law firm, companies decide how they will manage the day to day tasks of a plan. This may include updating the cap table, exercising and processing grant agreements, terminations and calculating expenses for stock options issued.

While some companies leave these tasks to their law firm, others may find this too expensive and may opt to manage these tasks on their own. They continue to consult with their law firm on the plan while choosing to manage day to day tasks internally. In the beginning, some companies decide to manage their equity compensation plans on spreadsheets.

But many find that the company outgrows that option very quickly once the business gets bigger and or expands globally. For this reason, many companies choose an equity compensation platform like Shareworks by Morgan Stanley to grow with them. Shareworks platform editions support private companies in all stages of growth. Shareworks by Morgan Stanley has helped thousands of companies with the administration of their stock option and equity compensation plans.

Our clients include startups, emerging companies and global public companies, such as Uber, Dropbox and Atlassian. We welcome the opportunity to show you how Shareworks can help you solve your equity plan management challenges. See tips for your private company's global communication plan on equity-based compensation to plan particip Learn about employee stock option plans.

How to Consider Equity Compensation When You Work for a Private Company

From the benefits to how to set up an employee stock option plan. Comprehensive Equity Management Trusted by many of the top companies in the world. Learn how Reddit offers broad-based equity plans to employees as part of its new culture globally. Learn the different types of dilution of shares in our equity dilution guide. View industry benchmarks by investor stage, typical dilution rates and more. Find out how to calculate equity dilution online with Shareworks Startup Edition.

Learn a stock dilution formula, see common equity dilution scenarios and more. In part two of our equity guide, we answer how does equity get diluted and work. Learn about anti-dilution protection and view an equity dilution example. View our Transparency Addressing Gaps in Equity Compensation report to learn about gaps and inequities that might exist in equity compensation plans. Watch our state of equity plan management webinar to learn about the state of equity compensation at private companies.

See things to consider with international tax regulations when offering equity to employees in multiple countries. With the risks of short exercise windows for employees becoming more widely known, longer exercise windows are gradually becoming more prevalent. As an employee or a founder, it is fairer and wiser to understand and negotiate these things up front, and avoid unfortunate surprises. The FAST templates give some typical guidelines about this. Confusingly, lawyers and the IRS use several names for these two kinds of stock options, including statutory stock options and non-statutory stock options or NSOs , respectively.

ISOs are common for employees because they have the possibility of being more favorable from a tax point of view than NSOs. But ISOs have a number of limitations and conditions and can also create difficult tax consequences. The option holder becomes a stockholder sooner, after which the vesting applies to actual stock rather than options. This will have tax implications. While stock options are the most common form of equity compensation in smaller private companies , RSUs have become the most common type of equity award for public and large private companies.

Facebook pioneered the use of RSUs as a private company to allow it to avoid having to register as a public company earlier. Each unit represents one share of stock or the cash value of one share of stock that the employee will receive in the future.

How to Understand Private Company Stock Options

RSUs are difficult in a startup or early stage company because when the RSUs vest, the value of the shares might be significant, and taxes will be owed on the receipt of the shares. But for cash-strapped private startups, neither of these are possibilities. This is the reason most startups use stock options rather than RSUs or stock awards. RSUs are often considered less preferable to grantees since they remove control over when you owe tax. Options, if granted with an exercise price equal to the fair market value of the stock, are not taxed until exercise , an event under the control of the optionee.

If the shares are worth a lot on the date of vesting , the tax burden can be significant. Usually you need the cash to buy shares—maybe more than you can afford to pay at exercise time.

What are Employee Stock Options?

Another, less common approach to be aware of is for companies to allow the person exercising options to avoid paying the cash up front and instead accept a promise of payment in the future. The note may either be a recourse promissory note or non-recourse promissory note. If the note is non-recourse, for state law purposes the company will consider you an owner of the shares received in exchange for the non-recourse note, but the IRS will consider the shares still an option until the promissory note is paid which would also affect timing for long-term capital gains.

Of course, use of promissory notes is complex and entirely at the discretion of the company. Individuals considering the idea should discuss with a lawyer as well as the company. While most employee equity compensation takes the form of stock, stock options , or RSUs , a complete tour of equity compensation must mention a few less common forms.

Phantom equity can have significant value, but may be perceived as less valuable by workers because of the contractual nature of the promises. Phantom equity plans can be set up as purely discretionary bonus plans, which is less attractive than owning a piece of something. Two examples of phantom equity are phantom stock and stock appreciation rights :. For example, in a convertible note offering, investors may also get a warrant, or a law firm may ask for one in exchange for what is in essence vendor financing.

They differ from stock options in that they are generally shorter, stand-alone legal documents, not granted pursuant to an equity incentive plan. The awarding of equity compensation can give rise to multiple types of taxes for the recipient, including federal and state income taxes and employment taxes. Skip ahead to understand how taxes on equity work, but if you have time, this section gives a technical summary of tax fundamentals, just in case you like most people!