Startup equity instruments like stock options, SAFEs, and convertible notes come with complex U.S. tax rules. Founders need to understand how each is taxed and when key tax events occur (vesting, exercise, conversion, sale) to avoid costly surprises and make informed decisions. This article explains the tax treatment of common equity instruments (ISOs, NSOs, SAFEs, and convertible notes), highlights critical considerations such as Section 83(b) elections and Qualified Small Business Stock (QSBS) exclusions, points out common pitfalls, and shows how ERB can help with planning, compliance, and reporting.
Stock Options: ISOs vs. NSOs
Stock options give the holder a right to buy company shares in the future at a set price (the strike price). There are two types:
- Non-Qualified Stock Options (NSOs) – can be granted to anyone (employees or others). Tax is due at exercise: the spread between the share’s fair market value and the strike price is taxed as ordinary income. For employees, the company must withhold payroll taxes on that income. After exercise, any further increase in value is taxed as capital gain when the stock is sold (with long-term capital gains rates applying if held for more than a year post-exercise).
- Incentive Stock Options (ISOs) – for employees only, with special tax advantages. No income tax is due at exercise of an ISO (though a large spread can trigger Alternative Minimum Tax). If the shares are held long enough after exercise (more than 1 year from exercise and 2 years from grant), all the gain on sale qualifies for long-term capital gains tax rates. Selling earlier (a disqualifying disposition) means some of the gain is taxed as ordinary income instead of at the lower rate.
Important: To avoid steep penalties, options should be granted with a strike price at or above current fair market value. Under Section 409A, discounted stock options (granted below FMV) can cause immediate taxable income and a 20% penalty to the recipient, so startups need a proper 409A valuation to set option prices.
Restricted Stock and Section 83(b)
When founders or early employees receive restricted stock (shares that vest over time), by default they are taxed on each portion as it vests. If the company’s value rises, vesting can trigger taxes on a much higher value later on. A Section 83(b) election lets you instead elect to pay tax on the stock’s value at the time of grant (which is usually very low) and not at vesting. After making an 83(b) election, no further tax is due until you ultimately sell the shares (then any gain is taxed as capital gain). This is often a huge tax saver for founders.
The catch: the election must be filed within 30 days of the stock grant. If you miss the 30-day window, you can’t retroactively get these benefits and will be stuck with taxes at each vesting event.
SAFEs (Simple Agreements for Future Equity)
SAFEs (Simple Agreements for Future Equity) are contracts where an investor gives money now for the right to receive equity in the future. Tax-wise, a SAFE is generally neutral until it converts. There is no tax when the company receives SAFE funding (it’s not treated as income), and no tax at conversion when the SAFE turns into stock (it’s like buying stock at the agreed terms). The investor’s cost basis in the shares is the amount they paid for the SAFE.
Only when those shares are eventually sold would a taxable gain or loss occur. (If the shares meet the criteria for Qualified Small Business Stock and are held 5+ years, the investor might exclude much or all of the gain under Section 1202.) For founders, the key point is that using SAFEs to raise capital doesn’t create a tax bill at funding or conversion.
Convertible Notes
Convertible notes are loans that eventually convert into equity. For tax purposes, raising money using a note is not income to the company (it’s a liability). The note will typically accrue interest, which for the investor is ordinary income and for the company is a business expense. Many times that interest is just rolled into the principal on the note and, ultimately, is converted into equity. The event of converting the debt to stock is not a taxable event, because that event is treated as an exchange of one asset (the note) for another (the shares). The only potential taxable portion may be the accrued interest: that is, when it converts into stock, the investor should recognize that interest income at the time of conversion. Once converted, any gain on the stock when sold is capital gain. In short, convertible notes defer tax consequences until either interest is paid or the stock received from the conversion is sold at some time in the future.
Sale of Shares and Exits (Capital Gains and QSBS)
Any time you sell shares (during an exit or liquidity event), any gain will be subject to capital gains tax. If you held the shares for more than one year, it is a long-term capital gain and will be taxed at the long-term capital gains tax rates; if you held the shares for one year or less, it is a short-term capital gain (taxed at your regular income rates). Founders should try to satisfy the long-term holding period, when possible, to minimize their taxes. Also, be aware of what’s called Qualified Small Business Stock (QSBS).
Under Section 1202, if your start-up is a C-Corporation, and the stock was acquired at original issue, and the stock is held for more than five years, you’ll be able to exclude a large percentage of the gain on sale – and, in fact if your gain on sale is up to $10 million (or 10 times your investment) it can be completely tax-free federally.
Many founding shares and early investor shares qualify. This has huge upside potential for tax savings; make sure to not do anything that unwittingly challenges you or your company in order for your stock to qualify for this treatment (i.e. changing your entity type, selling too early, etc. – work with your own trusted advisors to understand how to maximize this from the outset).
Common Tax Pitfalls for Founders
Even savvy founders can run into trouble with equity taxes. Some pitfalls to avoid include:
- Missing 83(b) Election: If you don’t file an 83(b) within 30 days of a restricted stock grant, you’ll be taxed on each vesting portion later at a much higher value.
- Surprise Tax on Option Exercises: Exercising options can trigger large tax bills. NSOs create immediate taxable income (with withholding), and ISOs can incur AMT. Plan ahead and budget for these taxes before you exercise.
- Section 409A Issues: Granting options below fair market value (without a proper valuation) violates 409A, causing immediate tax and a 20% penalty for the recipient. Always set option strike prices based on a 409A valuation.
- Withholding/Reporting Errors: Failing to withhold or report taxes on equity income (for example, not withholding on an NSO exercise or not issuing required tax forms) can lead to company penalties. Stay on top of these requirements.
- Overlooking QSBS: Not realizing your stock could qualify for a QSBS exclusion (or taking actions that disqualify it) can cost you a huge tax break. Learn the QSBS rules early so you can preserve that benefit.
How Outsourced Financial Services Can Help
An outsourced finance/tax provider can be an invaluable partner to a startup when it comes to equity and taxes:
- Tax Planning: Seasoned experts advise on the timing and structure of equity moves to minimize taxes. For example, they can project the AMT impact of exercising ISOs or determine if an 83(b) election will save you money.
- Compliance & Reporting: ERB can handle the paperwork and regulatory steps. We coordinate 409A valuations to set fair option prices, maintain your cap table records, and take care of tax filings (e.g. preparing 83(b) letters, issuing required IRS forms for equity transactions, and ensuring proper payroll withholding on exercises). This prevents costly compliance mistakes.
- Financial Expertise: With an outsourced CFO service, you gain peace of mind. These professionals have seen startup equity issues many times, so they can answer tricky questions, flag risks early, and smoothly manage the process during big events like funding rounds or an acquisition. That frees you to focus on growing the business.
Equity is often the lifeblood of a startup – it attracts talent and capital – but it comes with tax obligations that founders can’t afford to ignore. By understanding how stock options, SAFEs, convertible notes, and other equity instruments are taxed, and by keeping an eye on key events like vesting, exercises, and stock sales, you’ll be prepared instead of surprised. Always remember elections like the 83(b) and opportunities like QSBS that can dramatically affect your tax outcome. With the right planning and support, ERB can navigate the tax complexities of startup equity and keep more of the rewards from your company’s success.