So what type of stock options should California and Idaho start-up founders offer their employees? This can depend on your goals.

There are two types of stock options a start-up founder can offer: nonqualified stock options (“NSO”) and incentive stock options (“ISO”). These terms are IRS tax classifications so the primary difference is how the IRS treats them.

NSOs can be granted to employees as well as consultants, advisors, and directors. NSOs can come with a vesting schedule but do not have to. NSOs do not qualify for ISO tax benefits so NSOs are taxed when they are exercised. This tax is calculated by the spread (or difference) between the fair market value at the time it was purchased and the exercise price). This amount is then treated as ordinary income tax. Additionally, NSOs do not quality for 83(b) election.

A better (and more commonly granted) option is the ISO. Unlike the NSO, ISOs may only be offered to employees and come with fewer restrictions. ISOs come with no income tax liabilities at the time they are exercised, but, the employee does have to pay a tax on the amount the fair market value exceeds the option price (Alternative Minimum Tax or AMT). ISO’s are a popular stock option for employees of a start-up and typically come with a vesting schedule. Additionally, ISOs qualify for 83(b) election (see blog post about 83(b) election).

Whichever type of stock options founders decide to offer, its important that they learn and understand the potential tax ramifications. Contact Attorney’s at Fisher, Hudson, Shallat to discuss how to best compensate your start-ups employees.