By Matthew Barbieri, Partner

It’s becoming more popular to offer stock options to new hires as an incentive, especially if you’re on a limited startup budget. While you may not be able to offer new hires a world-class salary just yet, you can throw stock options into a compensation package to sweeten the deal.

However, it’s easy for both you and your employees to be blissfully unaware of some key details about holding and converting stock options.

To avoid confusion down the road, it’s important to understand how to properly issue stock options and be able to discuss related taxation guidelines with your new and existing employees. 

How do stock options work?

Think of options as a gift certificate an employee can use to purchase stock in your company at a flat per-share price that doesn’t increase over time. Ideally, they’ll be able to purchase shares below market value, then sell them at a higher price — resulting in a significant gain.

If the grantee goes about this process the right way, this form of compensation can be a great perk that doesn’t require any up-front investment.

Of course, they can’t cash in right away. It’s customary to make stock option conversion contingent upon one or more conditions, such as staying with the company for a minimum vesting period.

Warning: Options are not taxed as investments!

Granting stock options should be about more than handing over a piece of paper. It’s best to ensure your employees understand the taxation rates they’ll face when they go to convert this paper into shares.

Therefore, you should understand them first.

Because they’re offered in exchange for work, stock options are considered compensation. The difference between the current market value of an employee’s options and the amount they paid is taxed as income — i.e., at a higher rate than capital gains. It’s common for option holders to wrongly assume they’ll walk away with about 80% of the fair market value of their shares when, in fact, it could be a lot less (depending on their income tax rate).

To have them work out as a true asset, stock options should be converted into an investment. Stock transactions are only taxed advantageously for investors, which employees are not until they own stock shares instead of that piece of paper!

We believe stock options can be a win-win, but both parties — employer and employee — should be educated about the tax liability they’re taking on. 

Things to note when offering stock options to employees: 

• Stock options are like a gift certificate that can be used to purchase stock in your company at a flat per-share price that doesn’t increase over time
• Since they’re offered in exchange for work, stock options are considered compensation
• It’s wise to convert options into shares early on so they can be taxed as investments, rather than income

This article is based on an episode of the WTFAQ Podcast. Get straightforward answers to all your startup questions from Wiss CPA Matthew Barbieri.