Startup Equity Compensation and Payroll
Equity is how most startups pay for talent, and it creates tax events for employees that are often misunderstood. Payroll and worker classification create employer obligations from the first hire. Both are easier to handle correctly from the start.
Equity types
| Type | General tax treatment | Key planning point |
|---|---|---|
| Incentive stock options (ISOs) | No regular tax on grant or exercise, if rules are met. Exercise spread can trigger the alternative minimum tax (AMT). Sale can qualify for capital gain treatment | Holding period rules and AMT exposure at exercise |
| Nonqualified stock options (NSOs) | Spread at exercise is generally ordinary income and subject to withholding | Withholding and payroll reporting at exercise |
| Restricted stock units (RSUs) | Generally taxed as ordinary income when shares are delivered | Withholding on delivery; shares may need to be sold to cover tax |
| Restricted stock with 83(b) | Taxed at grant on the value at that time | The 30-day 83(b) deadline |
409A valuations
Stock options generally must be granted at no less than fair market value to avoid penalties under Section 409A. Companies usually obtain an independent valuation to set the strike price. A valuation becomes stale after material events, such as a new funding round, so the company should refresh it on a regular schedule and after significant changes.
Payroll setup
- Register for federal and state employer accounts before the first payroll.
- Withhold income and payroll taxes on wages, and on NSO spreads and RSU deliveries.
- File quarterly payroll returns, typically Form 941, and annual wage reports.
- Set up a payroll provider or process that can handle equity withholding.
Contractors versus employees
Startups often use contractors early. Misclassifying an employee as a contractor can create back payroll tax, penalties and benefits claims. The test looks at the facts: control over how and when the work is done, who provides tools and workspace, how the worker is paid, and whether the relationship is ongoing. Use a documented classification review before engaging a worker, not after a problem.
Planning checklist
- Set up a cap table and equity ledger that records grant dates and vesting.
- Obtain a current 409A valuation before granting options.
- Give employees written explanations of the tax treatment of each equity type.
- Review worker classification for every contractor engagement.
- Calendar payroll filings and deposits.
General educational information. Equity and payroll rules are technical and depend on plan terms, the state and the individual employee. Consult a qualified CPA and employment counsel before granting equity or classifying workers.