Stock options are an increasingly popular incentive offered to employees of tech start-ups. They are a way to reward employees for their contributions and motivate them to invest themselves in the company’s success and growth. If you are considering offering stock options for your start-up, there are several financial and tax reporting elements that you should be aware of.
When determining the effect of stock options on the financial statements, the first step is to determine the fair value of the option at the grant date. One of the most commonly used methods is the Black-Scholes formula, which requires several inputs in the calculation: the exercise price and expected term of the option, the risk-free rate for the expected term, the current price of the underlying share, the expected volatility of the price of the underlying share for the expected term, and the expected dividends from the underlying share, if any. Once the option’s fair value is determined, a company can estimate the total compensation cost by applying the fair value to the number of awards that are expected to vest at the beginning of the requisite service period, which is determined based on service conditions such as vesting requirements, market conditions, and performance conditions. The total compensation cost will then need to be recognized over the length of the requisite service period. At each reporting date, the period-to-date stock option compensation expense will be reported in the income statement and the corresponding stock option awards will be reported as equity on the balance sheet.
To obtain the value of the underlying share in a stock option, companies must utilize a 409a valuation. A 409a valuation, which is required by the IRS, applies the market approach, income approach, or asset approach to appraise the fair market value of the company’s common stock. Furthermore, it discloses various inputs used in its calculations, such as the risk-free rate and asset volatility rate, that can also be used in the Black-Scholes formula. While it is possible to perform a 409a valuation internally, utilizing an independent valuation firm is the least risky approach because it provides a safe harbor for tax purposes. Companies are required to obtain a new 409a valuation before they issue their first stock options, every 12 months thereafter, or after a new round of financing.
From a tax standpoint, there are two kinds of stock options – statutory and nonstatutory. Incentive Stock Options (ISO’s) are statutory because they are specified in the Internal Revenue Code (IRC) and subject to numerous requirements. Options that do not meet the requirements of ISO’s are nonstatutory stock options (NSO’s). Both have unique tax consequences as follows.
Option Grant – ISO’s are not taxed at the time the option is granted. Generally, NSO’s are not taxed at the time the option is granted unless it has a “readily ascertainable” fair market value (FMV). Rarely will an NSO meet the definition of a “readily ascertainable” FMV and those circumstances are beyond this discussion.
Option Exercise – This is where ISO’s and NSO’s tax treatment differ greatly. Upon exercise, an ISO is not subject to regular income tax, however, alternative minimum tax (AMT) may apply. For AMT purposes, you must add back the difference between the FMV at the time of exercise and what you paid for the exercise of the option. Depending on the spread and amount of options exercised, this may subject you to additional tax for AMT purposes. A word of caution: if you sell the stock within two years of the option grant or within one year of the option exercise, you will have ordinary income on that spread.
When you exercise an NSO, you are taxed at ordinary income tax rates on the difference between the FMV and the amount you paid to exercise the option. Both Federal and State taxes must be withheld on this additional compensation as well as applicable payroll taxes. The amount is reported on a W-2 and the Company will receive a tax deduction for the additional compensation of the employee. For non-employees, the additional compensation will be reported on a Form 1099-Misc under Box 7.
It is important to note that for Qualified Small Business Stock (QSBS) under IRC 1202, the 5-year holding period does not start until an option is exercised and the individual owns the QSBS.
Stock options are a great way to attract top talent in a competitive job market. Don’t let the complexities involved in issuing these awards deter you. Sciarabba Walker is committed to guiding you through each step of the process. Please contact us for additional assistance.
By Katie Fisher, CPA and Jeff Gorsky, CPA