This guide is general legal information, not legal advice, and does not create an attorney–client relationship. Rules change and vary by state — verify current requirements with official sources or a licensed attorney.
An equity grant is three documents doing three different jobs: a plan that authorizes awards and sets the rules, a board approval that issues a specific award on a specific date, and an award agreement the recipient signs. Companies that treat equity as an informal promise — "you'll get two percent" in an offer letter — create problems that surface years later, usually during a financing or a sale, when someone finally reconciles the cap table against the approvals.
This guide covers what a private-company equity plan contains, how the main award types are taxed, and the deadlines and valuations that cause the most expensive mistakes. Tax and securities rules here are federal; the corporate mechanics of authorizing and issuing shares are state law, and state income tax adds another layer.
Key takeaways
- Incentive stock options (ISOs) are available only to employees and carry statutory holding periods; nonqualified options (NSOs) generally produce ordinary income at exercise.
- A section 83(b) election must be filed within 30 days of the transfer of restricted property — a statutory window with no general extension.
- Options priced below fair market value at grant can trigger deferred-compensation penalties, which is why private companies obtain independent valuations.
- Issuing equity to service providers is a securities offering; private companies typically rely on the SEC's Rule 701 exemption plus state requirements.
- Every grant needs board approval and an updated cap table — undocumented promises become diligence findings and price adjustments.
The plan, the pool, and the paperwork
An equity incentive plan is adopted by the board and, for tax and securities purposes, approved by stockholders. It authorizes a pool of shares, names the award types permitted, sets the administrator, and states the standard terms: exercise periods, treatment on termination, change-of-control provisions, and transfer restrictions.
The pool is a real constraint. Shares reserved for the plan must fit inside the corporation's authorized share count, and increasing authorized shares requires a charter amendment approved by stockholders under state law — for Delaware corporations, under the General Corporation Law. Every other state has its own procedure. Investors negotiate pool size at each financing round because it dilutes them.
The grant itself is a board action, not an HR action. A valid grant needs an approving resolution or written consent identifying the recipient, the number of shares, the exercise price, the vesting schedule, and the grant date. Sloppy sequencing — an offer letter promising options months before any board approval — creates ambiguity about grant date and price, which is exactly what auditors and buyers probe. That discipline is part of the records practice covered in our guide to governance for private companies.
The main award types
| Award | Who can receive it | Tax at grant | Tax at vesting/exercise | Tax at sale |
|---|---|---|---|---|
| Incentive stock option (ISO) | Employees only | None | No regular income tax; spread is an alternative minimum tax adjustment | Capital gain if holding periods met; otherwise partly ordinary income |
| Nonqualified stock option (NSO) | Employees, contractors, directors, advisers | None (typical private grants) | Ordinary income on the spread at exercise; withholding for employees | Capital gain or loss on later appreciation |
| Restricted stock | Anyone | None unless an 83(b) election is made | Ordinary income as shares vest, on value at vesting | Capital gain from the taxed amount |
| Restricted stock unit (RSU) | Anyone | None | Ordinary income when shares are delivered | Capital gain from delivery value |
The IRS summarizes the option rules at Topic No. 427: with a statutory option, you generally include nothing in gross income on receipt or exercise, and tax arrives when the stock is sold — but failing to meet the holding-period requirements converts part of the gain into ordinary income. For a nonstatutory option without a readily determinable fair market value, which describes nearly every private-company grant, you include the value of the stock received on exercise less the amount paid, at exercise.
What makes an ISO an ISO
ISO treatment is conditional, and the conditions are statutory. The recipient must be an employee of the company or a parent or subsidiary. The exercise price must be at least fair market value at grant (higher for large stockholders). The option must come from a stockholder-approved plan and expire within ten years. There is an annual limit on the value of stock that may first become exercisable as an ISO in a calendar year — measured by grant-date value, and currently $100,000 — with the excess treated as an NSO.
Favorable treatment on sale also requires meeting both holding periods: the shares must be held more than two years from the grant date and more than one year from the exercise date. Sell earlier and the transaction is a disqualifying disposition, generally producing ordinary income on the exercise-date spread. Employers must furnish Form 3921 after an ISO exercise, which supplies the dates and values needed for the calculation.
Watch the alternative minimum tax: Exercising an ISO and holding the shares creates an AMT adjustment equal to the spread, even though no cash changed hands and no regular tax is due. Employees who exercise a large ISO position in a private company can owe substantial tax on paper gains in stock they cannot sell. Model this with a tax adviser before exercising, not in April.
Restricted stock and the 30-day election
Restricted stock is actual stock, issued now, subject to a repurchase right or forfeiture condition that lapses over time. Because the property is substantially nonvested, the default rule taxes the recipient as it vests, on the value at each vesting date — punishing if the company's value rises quickly.
A section 83(b) election reverses the timing: the recipient elects to be taxed at transfer, on the value then (often nominal for founder shares), and all later appreciation is capital gain. The election must be filed with the IRS within 30 days after the property is transferred. That window is statutory, it runs from transfer rather than from vesting, and missing it generally cannot be fixed. The election is also a bet — if the shares are later forfeited or lose value, the tax paid is not recovered.
RSUs sidestep the problem differently: nothing is issued until settlement, so there is nothing to elect on. That is administratively simpler but removes the possibility of long-term capital gain on pre-vesting appreciation, and private companies often add a liquidity condition so recipients are not taxed on shares they cannot sell.
Vesting, cliffs, and what happens on exit
Vesting schedules are market practice, not law. The common private-company pattern is four years with a one-year cliff, then monthly or quarterly vesting; alternatives include milestone vesting tied to product or revenue targets and shorter schedules for advisers. Several award-agreement terms matter more than the schedule itself:
- Post-termination exercise period. The traditional 90-day window forces departing employees to fund an exercise and its tax without a market for the shares; some companies extend it, which converts ISOs to NSOs after three months.
- Cause and good-reason definitions. These decide whether vested equity survives a separation, and they belong in the award agreement rather than only in an employment contract.
- Acceleration. Single-trigger acceleration vests on a change of control; double-trigger requires a change of control plus termination. Acquirers care about this, so it becomes a negotiation point in every deal.
- Repurchase rights. Whether the company may buy back vested shares on departure, and at what price.
- Right of first refusal and transfer limits. Almost always present in private companies, and enforced through the stock ledger.
These provisions intersect with separation practice generally, including the release terms discussed in our guide to termination and severance agreements.
Valuation, 409A, and securities law
Two compliance layers sit under every private grant.
Valuation. Section 409A of the tax code treats a discounted option — one with an exercise price below fair market value at grant — as deferred compensation, exposing the recipient to accelerated income inclusion plus an additional tax. Private companies avoid this by obtaining an independent valuation supporting the exercise price, refreshed periodically and after material events such as a financing. This is why "409A valuation" is a routine line item in startup budgets.
Securities law. Granting equity to employees and other service providers is an offer and sale of securities. Private companies commonly rely on Rule 701, which exempts compensatory issuances by non-reporting companies under a written plan or agreement, subject to volume limits and to enhanced disclosure — including financial statements — once sales in a twelve-month period exceed a stated threshold. State blue-sky requirements apply in parallel. Companies that grant heavily without tracking the exemption conditions create a rescission-risk finding that surfaces during legal due diligence.
One clarification worth making: equity incentive plans are generally not employee benefit plans under ERISA, which governs retirement and welfare plans through the Department of Labor's Employee Benefits Security Administration. A company's 401(k) and health plans live in that regime; its option plan does not. Payroll withholding and reporting obligations, described at the IRS Small Business and Self-Employed Tax Center, still apply to taxable equity events for employees.
Equity in an LLC works differently
LLCs cannot issue ISOs, and options over membership interests are awkward. The usual substitute is a profits interest — a grant entitling the holder to future appreciation and profits above a threshold value set at grant, which can be structured to produce no taxable income on receipt when the requirements are met. Holders typically become members for tax purposes, which changes their tax reporting and can end employee treatment. Any of this requires amendments to the operating agreement, and companies planning institutional financing often convert to a corporation instead — one of the tradeoffs weighed in our guide to choosing a business structure.
Frequently asked questions
Should I early-exercise my options?
Only if the plan permits it and the numbers support it. Early exercise plus a timely 83(b) election can start the capital-gain clock and limit ordinary income, but it means paying cash for shares that may become worthless and may create an AMT adjustment for ISOs. It is a personal financial decision that depends on the spread, your liquidity, and your view of the company.
What happens if I miss the 83(b) deadline?
The election window is 30 days from transfer and there is no general relief for missing it. The default rules then apply: you are taxed as the shares vest, on their value at each vesting date. Because the deadline is unforgiving, file promptly, keep proof of mailing, and retain a copy with your tax records.
Can contractors and advisers get options?
They can receive NSOs, restricted stock, or RSUs, but not ISOs, which are limited to employees. Grants to non-employees also carry different tax reporting and, in some cases, different valuation considerations. Confirm the person's classification first, since misclassifying a worker creates problems well beyond the equity grant.
How large should the option pool be?
There is no legal answer; it is a negotiation between dilution and hiring needs. Companies typically size the pool against a hiring plan covering the next twelve to twenty-four months, with investors pressing for a larger pool established before their investment so the dilution falls on existing holders. Revisit the pool at each round rather than authorizing a large one at formation.
Do we need a lawyer to grant options?
For plan adoption, valuation practice, and securities-exemption compliance, yes — those are the points where mistakes are expensive and hard to unwind. Routine grants under an established plan can be handled internally with templates, provided each grant is board-approved, documented, and recorded on the cap table on the date it is made.
Getting it right from the start
Set the sequence and keep it: adopt the plan, obtain a valuation, approve grants by board consent at a stated price and date, issue the award agreement, record it on the cap table, and file the required information returns. Reconcile the cap table to the approvals at least annually. Companies that do this spend little on equity administration; companies that do not spend heavily on cleanup at exactly the moment they can least afford delay.
Recipients should treat grants as a tax event waiting to happen — particularly ISOs held into a high-value year and restricted stock whose 83(b) window closes quickly. Related material sits in our business and corporate law topic hub. This article is general information and not legal or tax advice; equity compensation rules are technical, and state tax treatment varies.
