Anthony points to a good overview on equity-based compensation. Motivation issues aside, such plans are also a key means to attract and keep top talent when you might not otherwise have the means (i.e., an early stage startup).

The article discusses the three primary forms of equity - Incentive Stock Options (ISOs), Non-qualified Options (NQOs), and a stock bonus plan.

ISOs are preferable because of the tax treatment for the recipient, but there are stricter requirements in issuing them. A brief matrix outlining the tax implications of ISOs and NQOs is below.

Event ISO - Tax to Employee ISO - Tax to Employer NQO - Tax to Employee NQO - Tax to Employer
Grant None None None (if close to FMV) None
Exercise None None Ordinary Income None
Sale of Stock Capital gains above exercise tax None Complicated (if held for 2 years, capital gains only) None

As I briefly discussed with regard to the options scandals, the goal is to postpone and potentially lower the tax to the recipient.

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