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rakhi.v, Tax Attorney
Category: Tax
Satisfied Customers: 3906
Experience:  Have graduated in Law with specialization & emphasis in Financial Laws and has working experience of over a decade.
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Start-Up Offer: Restricted Shares vs. Non-Qualified Options

Customer Question

Start-up Equity. Suppose I were offered 1% equity in restricted shares and 1% in non-qualified stock options (NSOs) as part of a compensation package at an early stage startup, where the shares and options are subject to a 4-year vesting schedule with a 1-year cliff. The current FMV is very low.


 


1. Is the following correct? I could take an 83(b) Election and pay ordinary income tax on the restricted share grant now. I would owe no further taxes on the restricted shares until the time of their sale, at which time I would only pay long-term capital gains (LTCG) as long as I've held the shares for more than 1 year.


 


2. If I have a choice, is it correct that it would be more beneficial to have the restricted shares vest before the NSOs? My concern is having to potentially exercise NSOs at a high FMV in the case of a termination of service (e.g., 2 years into my employment), which would leave me with a huge tax burden for that year. 


 


3. Finally, the company has claimed that their attorneys advised them not provide more than half the equity as restricted shares, and that this is their rationale for offering half as NSOs. I see the NSOs as a large risk primary because if there were a termination of service for any reason prior to an exit event which would allow me to liquidate my vested options, I would be faced with taking on a large tax burden for that year in order to exercise the vested options. 


 


Would it make sense to attempt to negotiate a combination of restricted shares and ISOs totaling 1.9% or 1.8% if I think the expected exit price will be sufficiently high? Is it more favorable to have restricted shares or ISOs in this case?


 

Submitted: 1 year ago.
Category: Tax
Expert:  Anne replied 1 year ago.

Anne :

I'm sorry but your question is unclear to me, Are you asking how each of the options work?

Customer:

I believe I understand the basics of ISO vs. NSO vs. restricted shares. However, I have three specific questions.

Customer:

The first is to check my understanding of the 1% equity which has been offered as restricted shares. (See 1.) I need to rephrase the second questions, but I would like to know what would happen if I accepted the offer as is, with 1% equity as restricted shares and 1% as NSOs. They both have a 4-year vesting schedule. Would the restricted shares and the NSOs vest at the same time over the course of 4-years?

Customer:

Primarily, I am afraid of the possibility of being laid off or fired before my NSOs fully vest. In that cast, my understanding is that I would have two options: 1) walk away and not exercise my NSOs or 2) exercise my NSOs, in which case I would have to pay ordinary income tax on the difference between the fair market value and exercise price at that time. Currently, the FMV of shares is very, very low. In 12 months, it might be 10-100 times higher. So if, hypothetically, I were fired in 12 months, exercising my NSOs might mean having hundreds of thousands of dollars in ordinary income tax.

Customer:

Finally, my third question has to do with some counteroffers I am considering making. Because NSOs seem like a risky asset to me, I would prefer to have all of my equity in the form of restricted shares or incentive stock options (ISOs). I am considering giving up some equity (asking for a total of 1.8 - 1.9% instead of 2.0%) to make this happen. Should I ask for 1.8 - 1.9% in restricted shares? Or 1% in restricted shares and 1% in ISOs? What combination would the employer be more likely to accept?

Customer:

I will be on my computer tonight so please let me know if I can clarify any points further.

Anne :

hi

Anne :

I want you to have the best answer you can possibly have

Customer:

I'm sorry -- I typed out a long reply to your initial question but I am no longer seeing. Were you able to see the reply I sent to you?

Anne :

and I have another expert in mind that I think could REALLY look at this and give you a great answer

Anne :

he's not in the forum at the moment, but I can send him an email

Anne :

would that be ok with you?

Anne :

Oh........and I did see your reply

Anne :

would waiting until tomorrow after I send this expert an email be ok with you?

Customer:

Yes, but I haven't used this site before and want to repost my question as an urgent one. What should I do in the meantime?

Anne :

I can "opt out" which will put this question back on the open board, and any other experts currently online will have access to it

Customer:

Perfect. That would be great. I will edit my question for clarity and if you could direct the expert to my question I would greatly appreciate it.

Anne :

ok........I will opt out and send this expert an email

Customer:

Anne, were you able to opt out of this question?

Expert:  rakhi.v replied 1 year ago.
Dear Friend,

Hello and welcome. Thank you for using Just Answer. Let me attempt and throw light on your question to the nearest clarity as possible.

I have read your question in detail. Let me try and help you with your question.

1. When you talk of making 83b selection ---- As you are aware, Under Section 83 of the Internal Revenue Code, the founder/employee would not recognize income (the difference between fair market value and the price paid) until the stock vests. However, if a founder/employee makes a voluntary Section 83(b) election, the founder/employee recognizes “income” upon the purchase of the stock.

Typically, the purchase price for the stock and the fair market value are the same. Therefore, if an 83(b) election is made, there is no income recognized. Thus, a founder/employee should almost always make an 83(b) election. The benefits of an 83(b) election generally are starting the one year capital gain holding period and freezing ordinary income (or alternative minimum tax) recognition to the purchase date.

If the founder/employee does not make the 83(b) election, then he or she may have income at the stock “vests.” The income will be substantial if the value of the shares increases substantially over time.

So, your assumption with reference to point 1 is correct.

2. Again YES. If your possibilities of being laid off are higher and the fair market value is likely to increase manifold, just as you mention in your question. It would be more beneficial to have the restricted shares vest before the NSOs

3. So far as making counter offers goes, employers usually are rigid with what they offer. However, it is always wise to split your risk 50-50.I mean you can ask of 1% in restricted shares and 1% in ISO and so on. NSO are risky but moderately risky not much.

I am sure this would help.

You may please leave a positive rating if this helps as that is the only way we receive credit for assisting you. Alternatively feel absolutely free to revert with more queries if you have.

Warm Regards
Customer: replied 1 year ago.

Thank you for your answer.


 


To follow up on my second question, is it possible that both the restricted shares and NSO would vest simultaneously (so that each vests over the 4-year time period)?

Expert:  rakhi.v replied 1 year ago.
Dear Friend,

Hello and welcome. Thank you for your follow up question. Yes, that would be certainly possible.

I am sure this would help.

You may please leave a positive rating if this helps as that is the only way we receive credit for assisting you. Alternatively feel absolutely free to revert with more queries if you have.

Warm Regards
Expert:  rakhi.v replied 1 year ago.
Dear Friend,

I hope my reply helped. Let me know if I have missed out on any aspect of your question of if you need more clarity. I have taken care to include all points as such.

I am sure this would help.

You may please leave a positive rating if this helped as that is the only way we receive credit for assisting you.

Warm Regards
Customer: replied 1 year ago.

I would be happy to leave a positive rating, but I still am struggling to understand some of the details.


 


If I accept standing offer of 1% restricted shares and 1% NSOs, will they both vest over the 4-year time period unless I negotiate a different vesting schedule? This is what I meant to ask with my last question to you.


 


Also, why is the employer unwilling to issue more restricted shares or ISOs to me instead of NSOs? In my specific scenario, isn't the only advantage of NSOs to the employer that they can deduct the spread when I exercise them? Or is there something I am missing?

Expert:  rakhi.v replied 1 year ago.
Dear Friend,

Hello and welcome again. Thank you for your follow up question.

I mean that both restricted shares and NSOs CAN have same vesting period if you negotiate it. It would be same if you negotiate it otherwise.

The reasons that employers are usually unwilling to issues ISOs instead of NSOs is normally the advantages associated on part of the employer.

Incentive stock options (“ISOs”) can only be granted to employees. Non-qualified stock options (“NSOs”) can be granted to anyone, including employees, consultants and directors. I do not know in what capacity you are going to be associated with the start up.

It is also to prohibit employees to exercising it. So far as ISO goes, There is no taxable income to the employee at the time of grant or timely exercise. However, in case of NSOs * The income recognized on exercise is subject to income tax withholding and to employment taxes.

I am trying to convey that NSOs are more likely to be issued by the employer as it normally discourages the exercise unless if the person is ready to take tax on it.

So in most cases, one has to NEGOTIATE the component (% Components ) of restricted shares, ISOs or NSOs from the empoyers.

I hope this helps.

You may please leave a positive rating if this helped as that is the only way we receive credit for assisting you.

Warm Regards
rakhi.v, Tax Attorney
Category: Tax
Satisfied Customers: 3906
Experience: Have graduated in Law with specialization & emphasis in Financial Laws and has working experience of over a decade.
rakhi.v and other Tax Specialists are ready to help you
Customer: replied 1 year ago.

I see -- thank you for that detailed explanation. I did not think that NSOs might be issued to discourage employees from exercising. (And yes, I would be an early employee).


 


I am going to leave you a positive answer. Also, are you available for phone consultation / document review at an hourly rate? (And if so, do you have any U.S. tax or legal credentials? I wasn't clear from the site).


 


Thanks,


Alex

Expert:  rakhi.v replied 1 year ago.
Dear Friend,

Hello and welcome again. Thank you for your follow up conversation.

I do not say that is the only reason. But certainly one of the reason. The tax implication on the one who exercises is certainly bit bitter for NSOs than ISOs. However, many many factors go into this for the employee to decide what to offer and how much.

Secondly, we are bound by some terms of service which prohibits us from establishing any other form of contact.

You can certainly return on this platform again and begin your question by prefixing "For Rakhivasavada......" and you will reach me. You can attach / upload any document you may wish me to review it. I would be more than happy to keep assisting you.

Warm Regards

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rakhi.v
rakhi.v
Tax Professional
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Have graduated in Law with specialization & emphasis in Financial Laws and has working experience of over a decade.