INTRO STAT BLOCK (match QSBS page style — three key numbers)
| 30 Days | $100K | 1 Year |
|---|---|---|
| Window to file an 83(b) election — no exceptions, no extensions | ISO annual exercisability limit per employee per year | Minimum hold after ISO exercise to get long-term capital gains rates |
INTRODUCTION
Equity compensation is one of the most powerful tools a startup has — and one of the easiest to get wrong. Done correctly, it attracts and retains talent, aligns incentives, and can create life-changing wealth for founders and employees. Done incorrectly, it creates unexpected tax bills, securities law violations, disputes, and sometimes rescinded grants.
This guide covers everything you need to know: the types of equity, the tax rules, the compliance requirements, and the mistakes that are most expensive to fix.
If you need help designing or reviewing an equity compensation plan, schedule a consultation or reach out via the contact page.
1. The Four Main Types of Startup Equity
Startups can compensate service providers in four primary ways:
Restricted Stock is the grant of actual shares subject to vesting conditions and risk of forfeiture. It’s the simplest form and the most common for founders. Because you receive shares immediately, you can file an 83(b) election and start your capital gains holding period right away. Restricted stock is also outside IRC Section 409A, which simplifies compliance.
Stock Options give the recipient the right to buy shares later at a fixed exercise price. Options come in two flavors — incentive stock options (ISOs) and non-qualified stock options (NQSOs) — with very different tax consequences. Options are common for employees because the recipient doesn’t pay anything until they exercise, which means no upfront tax risk.
Restricted Stock Units (RSUs) are promises to deliver stock (or cash) once vesting conditions are met. RSUs are more common at later-stage companies and public companies. Unlike options or restricted stock, RSUs are taxable as ordinary income when they vest — there’s no way to elect capital gains treatment up front.
Profits Interests are used in LLCs taxed as partnerships. A profits interest grants the holder a right to future appreciation and profits without triggering tax on grant or vesting (if structured correctly). They’re the LLC equivalent of a stock option, but with better tax treatment in most cases.
2. Restricted Stock and the 83(b) Election
When you receive restricted stock subject to vesting, you have a choice: pay tax now on the current value, or pay tax later as the shares vest. The 83(b) election lets you choose to be taxed now — and if the company grows, this can save an enormous amount in taxes.
The 30-day rule is absolute. You must file the 83(b) election with the IRS within 30 days of the grant date. There are no extensions. There is no late filing relief. Missing this window is one of the most costly mistakes in startup equity law.
How to file: Send a signed election notice to the IRS Service Center where you file your returns, with a copy to your employer or the company. Keep a copy with proof of mailing. Some practitioners also recommend filing a copy with your tax return for the year of grant.
When it’s worth it: The 83(b) election is most valuable when the current fair market value of the stock is low — ideally at or near the exercise price. Early-stage founders receiving founder shares at a fraction of a cent per share have the most to gain. As the company’s value grows, so does the cost of missing the election.
3. Incentive Stock Options (ISOs)
ISOs are the gold standard of option grants for employees. If you meet all the holding period requirements, gains on ISO shares are taxed as long-term capital gains — not ordinary income. But the rules are strict.
ISO requirements:
- Can only be granted to employees (not consultants or independent contractors)
- Must be granted under a written plan approved by shareholders
- Exercise price must equal or exceed the fair market value of the stock at grant (no discounts)
- No more than $100,000 in options (measured by fair market value at grant) can become exercisable in any calendar year
- Must be exercised within 10 years of grant (5 years if the optionee owns more than 10% of the company)
- To get capital gains treatment, shares must be held at least 2 years from grant date AND 1 year from exercise date
The AMT trap. The spread on ISO exercise (the difference between fair market value and exercise price) is a preference item for alternative minimum tax purposes. In a bad year — or a failed IPO — exercising ISOs can create a large AMT bill with no cash to pay it. This is one of the most dangerous scenarios in startup equity.
Early exercise. If your options are immediately exercisable, you can exercise on the grant date when the spread is zero (or very small) and start your capital gains holding period right away. This is one of the most powerful strategies available to early employees.
4. Non-Qualified Stock Options (NQSOs/NSOs)
NQSOs don’t get the preferential ISO tax treatment, but they’re more flexible. They can be granted to anyone — employees, consultants, board members, advisors. There’s no $100K annual limit. And unlike ISOs, early exercise of NQSOs doesn’t create AMT exposure.
Tax treatment: When you exercise an NQSO, you owe ordinary income tax on the spread (fair market value minus exercise price). That spread is also subject to payroll taxes if you’re an employee. After exercise, any further appreciation is taxed as capital gains (long-term if you hold at least a year).
When NQSOs are better than ISOs: If you’re an early employee who can early exercise immediately (when spread is zero or trivial), an NQSO is actually preferable to an ISO. The reason: early exercising an ISO starts an AMT preference period even at zero spread, and the 83(b)-style election for ISOs doesn’t eliminate the AMT preference. An early-exercised NQSO, by contrast, has no spread, no income, no AMT issue — and you start your capital gains clock immediately.
5. Section 409A and Fair Market Value
IRC Section 409A is the tax law that governs deferred compensation — including stock options. The key rule for equity: if an option is granted with an exercise price below the fair market value of the underlying stock, it’s treated as deferred compensation and the optionee faces immediate tax on vesting plus a 20% penalty tax plus interest. This is catastrophic.
The safe harbor: A “409A valuation” performed by an independent appraiser creates a presumption that the exercise price equals fair market value. This protects the company and the optionee.
When to get one:
- Before any option grants
- Whenever there’s a material event (new funding round, significant revenue milestone, acquisition discussions)
- At least annually if you’re making regular grants
- Before a liquidity event
Cost: A basic 409A valuation from a reputable firm typically runs $1,500–$3,500 for an early-stage company. It’s cheap insurance.
Planning Tip: Build 409A refresh into your option grant calendar. A stale valuation is almost as dangerous as no valuation. If your last 409A is more than 12 months old — or there’s been a material change — get a new one before you grant.
6. RSUs: The Later-Stage Tool
Restricted stock units are more common at growth-stage and pre-IPO companies than at seed-stage startups. The reason: RSUs are taxable as ordinary income when they vest, and if the company’s stock isn’t publicly tradeable, you can have a tax liability with no cash to pay it (the “liquidity problem”).
The dual trigger. Most pre-IPO companies address this with a “double trigger” RSU — vesting requires both time-based service AND a liquidity event (IPO, acquisition). This delays taxation until there’s cash to pay it.
RSUs vs. Options: For employees at a company with a significant 409A FMV, RSUs can be better than options because you don’t have to pay an exercise price and you don’t face the AMT issues of ISOs. The tradeoff is that all upside is taxed as ordinary income rather than capital gains.
7. Profits Interests (LLC Equity)
If your company is structured as an LLC taxed as a partnership, the equity instrument of choice is typically a profits interest rather than a stock option. A profits interest gives the holder a right to future appreciation and profits — but not a share of current assets.
Tax treatment (if done right): No tax on grant, no tax on vesting, capital gains treatment on sale. This is significantly better than stock options in most scenarios.
The threshold value. At the time of grant, a profits interest must have a zero liquidation value — meaning if the company sold all its assets and distributed the proceeds, the profits interest holder would receive nothing. This is sometimes called the “threshold value” and is analogous to an option exercise price.
Documentation requirements: Profits interests should be documented with a grant agreement, the operating agreement should be updated, and the company should make a “safe harbor” election under Rev. Proc. 2001-43. Get counsel involved.
8. Rule 701 and Securities Law Compliance
Equity grants to employees and consultants are sales of securities. To avoid registration requirements, most private companies rely on Rule 701 of the Securities Act of 1933.
Rule 701 safe harbor: You can grant equity to employees, directors, officers, consultants, and advisors without registration, as long as the aggregate amount sold during any 12-month period doesn’t exceed the greatest of: (a) $1 million, (b) 15% of total assets, or (c) 15% of outstanding securities.
The $10 million threshold: Once you exceed $10 million in grants in a 12-month period, you must deliver enhanced disclosure to optionees, including financial statements. Many rapidly growing companies don’t realize they’ve crossed this threshold.
Consultants and advisors: Rule 701 is only available for “bona fide services” — not fundraising or capital-raising activities. Equity grants to people who are primarily raising money for the company require a different exemption.
9. Equity Intersects with QSBS
If you’re a C corporation, equity compensation planning and Section 1202 QSBS planning need to work together. A few key points:
- Founder shares can qualify as QSBS if all eligibility requirements are met at issuance. Early founders who receive shares at a penny per share (or even restricted stock with a low FMV) have the best chance of maximizing the Section 1202 exclusion.
- Options and RSUs generally don’t qualify as QSBS at grant. The shares acquired on exercise or vesting may qualify, but only if the company still meets all eligibility requirements at the time of acquisition.
- The $75M gross assets test applies at the time of original issuance. Companies that have grown beyond that threshold can no longer issue new QSBS — but previously issued qualifying shares retain their QSBS status.
For a full treatment of Section 1202 eligibility, see the QSBS & Section 1202 Pillar Page.
10. Vesting Structures
Standard vesting at startups: 4 years with a 1-year cliff. After 12 months of continuous service, 25% vests. The remaining 75% vests monthly over the following 36 months.
Variations to know:
- Immediate vesting / no cliff — Sometimes granted to advisors or very senior executives. Higher risk for the company if the person leaves early.
- Back-weighted vesting — More shares vest in later years. Incentivizes long tenure.
- Milestone vesting — Vesting tied to performance goals rather than time. Common in executive employment agreements; requires careful 409A analysis.
- Acceleration — Single-trigger (change of control) or double-trigger (change of control + termination). Double-trigger is standard for employees. Single-trigger is sometimes granted to founders.
Founder Tip: If you’re a co-founder negotiating your initial equity split, build vesting into the founders’ agreement from day one — even if it feels awkward. Unvested founder equity is what protects the company if a co-founder leaves early. Investors will require it anyway.
11. Advisor Grants
Advisors are typically granted NQSOs (not ISOs, since ISOs require employee status) ranging from 0.1% to 0.5% of the company’s fully diluted shares, depending on stage and level of involvement. The FAST Agreement (Founder Advisor Standard Template) from the NVCA or Founder Institute provides a starting point.
Key terms:
- Vesting: typically 2 years monthly with no cliff, or milestone-based
- Exercise price: must equal FMV at grant date (409A required)
- Post-termination exercise period: advisors sometimes get longer windows than employees; negotiate this
Compensation vs. Investment: If an advisor is primarily helping raise money, their equity grant may not qualify under Rule 701. Consult counsel.
12. Common and Costly Mistakes
These are the equity mistakes that generate the most calls to a startup attorney:
- Missing the 83(b) deadline. Thirty days from grant, no exceptions. Set a calendar reminder the moment you receive a restricted stock grant.
- Granting options below FMV without a 409A. Triggers Section 409A penalties — 20% excise tax plus income tax plus interest. Always get a 409A before granting.
- Forgetting to get board and shareholder approval. Options must be authorized under an approved equity plan. Grants made outside the plan, or before shareholder approval, may need to be rescinded and reissued.
- Giving ISOs to non-employees. ISOs can only be granted to employees. Granting ISOs to consultants or independent contractors causes them to automatically convert to NQSOs — with no notice to the recipient.
- Stale 409A valuations. Using a valuation that’s more than 12 months old, or that pre-dates a material event, creates the same 409A risk as having no valuation at all.
- Overlooking state securities laws. Rule 701 is a federal exemption. Many states have their own notice and filing requirements. California is particularly active in this area.
- No clawback or repurchase right. If an employee leaves and exercises their vested options, the company has no way to buy back the shares. Consider including repurchase rights in your equity plan for early exercise situations.
- Equity to founders without IP assignment. Always — always — pair equity grants to founders with an IP assignment agreement. If a founder leaves early, you don’t want to be in a dispute over who owns the company’s core technology.
13. Getting Help
Equity compensation sits at the intersection of corporate law, tax law, and securities law. The mistakes are expensive. The planning opportunities — especially the interaction between equity, 83(b) elections, and Section 1202 QSBS — can be worth millions.
If you’re designing an equity plan, reviewing a job offer, or structuring grants for a new hire or advisor, we can help.
Schedule a free 20-minute call
Or send a message via the contact page.
Joe Wallin is a startup attorney at Carney Badley Spellman in Seattle. He holds an LL.M. in Taxation from NYU and co-chairs the Angel Capital Association’s legal advisory council. He is the author of Angel Investing: Start to Finsh.