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Granting Equity to Service Providers: What are the types of equity?

21 Aug

By:  Sheheryar T. Sardar, Esq.
Sardar Law Firm LLC
New York, New York
Core Practice Areas:  Technology, Corporate & General Counsel, Startup Law, Project Finance, VC/PE, Arbitration/Mediation, Entertainment, and Human Capital


There are 4 types of equity possibilites for C-Corps and S-Corps for purposes of granting equity to service providers.  It’s important for startups to understand the 4 types of equity possibilities in order to make the best decisions on which type to grant, and how much to grant.

(1) Non-Qualified Options  (NQOs)

NQOs are stock options that are not qualified as ISOs under the Internal Revenue Code.  Startups like NQOs because they provide a flexible way to attract and retain both employees and other service providers. For employees/service providers, NQOs represent an opportunity to grow wealth, with tax consequences deferred until the year the option is exercised.

(2) Incentive Stock Options (ISOs) 

ISOs provides unique tax benefits as a stock option, however with significant tax complexity.  It has become popular in the past few years, almost to the level of non-qualified stock options (NQOs). With ISOs, the drawbacks include: (1) you must report taxable income at the time you exercise the option to buy the stock, and (2) the income is treated as compensation, which is then  taxed at a higher rate than long-term capital gains. However, if you hold the stock long enough to satisfy a special holding period, it may be taxed as long-term capital gains instead of simple compensation.

There are also additional restrictions on the issuance of ISOs:

(1) ISOs can only be granted to employees, pursuant to a shareholder approved plan;

(2) ISOs must have a term not greater than 10 years (or 5 in certain circumstances);

(3) ISOs must have an exercise price not less than fair market value (or greater); and

(4) Not more than $100K in value can vest in any one (1) year time period.

There is also the issue of AMT, alternative minimum tax, which is a more complex calculation that you should review with an accountant.

(3) Restricted Stock/Stock Units (RSUs)

With RSUs, the company holds the shares to see if the employee continues working long enough to receive the shares and transfers the shares at that time.

Because the shares are not transferred at the grant date, the employee is not entitled to any dividends from the time the RSU is granted until the shares are transferred.  Also, since there is no actual transfer at the time the shares are granted, the employee cannot convert the future appreciation from compensation income to long-term capital gain.

As for the tax consequences, they are less complex: (1) when the RSU is granted, there is no tax to report; (2)  when the shares are transferred to the employee, the shares become vested and they need to report compensation income equal to the value of the shares at the time of transfer.

(4) Phantom Equity

This is a little known type of equity, but it’s been rumored to be the “next big thing” in employee compensation. Phantom equity pays a future cash bonus equal to the value of a certain number of shares.  Phantom equity provides a cash or stock bonus based on the value of a stated number of shares, to be paid out at the end of a specified period of time.  This can be based on a variety of complex, or intelligently drafted, contractual agreements between the employer and the employee/provider.

Stay tuned for Part II of this article: What type of equity to grant. 

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**This post is NOT intended as tax advice; please see disclaimer**
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