I don't understand tax obligations on options

Here's the situation:

• two founders each own 50% of the company
• angels / VCs / FFFs are about to invest
• the company will set up a 10% options pool for new hires

When a new hire starts, how do taxes on options work?

What is that employee's tax obligation?

It depends on the option type: ISO's or NSO's

Incentive Stock Options (ISO's)

These type of options can only be issued to employees. They have certain tax advantages, the biggest being that ISOs are taxed on the sale of the stock not the exercise of the option. This means that you can exercise your options and not have to worry about taxes until you actually sell the stock. Well, not exactly. You do need to look into Alternative Minimum Tax (AMT) triggers since that plays by a different set of rules (see below). Some of the other rules that ISO’s follow are:

• Must be granted at Fair Market Value (FMV)
• Non-transferable
• Must be granted 10-years after board approval
• Must be exercised 10-years after the grant date.

Nonqualified Stock Options (NSOs)

All other options, at a startup, are typically NSOs. NSOs are more flexible than ISOs but they don’t have the same tax advantages. The main thing about NSOs is that they are taxed when you exercise the option. This means they are taxed at ordinary income tax levels and you don’t get the benefit of long term capital gains. NSOs have the flexibility in terms of:

• Can be given to anyone
• Can be priced at, above or below the current market price, so no issues with FMV

Bottom line is as long as you don't exercise them, you have no taxable event. I would consult a tax professional or lawyer to make sure you are issuing the right type.