Employee Stock Options at Startups: A Founder’s Guide

Startup equity is compensation with a tax code attached, and the tax code is where most of the value is won or lost. The difference between an incentive stock option and a non-qualified one, between exercising in year one and year four, and between a US and a Canadian employer are each worth more than a plausible difference in grant size.

ISO, NSO and RSU

Three instruments cover almost every grant at a private company. The IRS sets out the treatment of each in Publication 5992 and in Tax Topic 427.

The statutory limits on ISOs come from section 422 of the Internal Revenue Code. An ISO must be exercisable no later than 10 years from grant. Where the aggregate fair market value of stock for which ISOs first become exercisable in a calendar year exceeds $100,000, the excess is not an ISO and is treated as an NSO. The employee must have been employed at all times from grant until the day three months before exercise, extended to one year for disability. A holder of more than 10% of the voting power can only receive an ISO priced at 110% of fair market value with a term of five years or less.

For capital gains treatment the employee must hold the shares at least two years from grant and one year from exercise. Fail either test and the sale is a disqualifying disposition: the IRS says the income “must be treated as ordinary income” and is treated as wages.

RSUs behave differently in a way that matters at private companies: there is no exercise price, so there is nothing to pay, but there is also no way to control the timing. Publication 5992 is explicit that an 83(b) election is unavailable because “Restricted Stock Units are not considered property for purposes of IRC § 83 since no actual property has been transferred.” At a private company with no liquidity, a vesting RSU produces a tax bill with no shares you can sell to pay it.

The 409A valuation is the number your grant hangs on

An option priced below fair market value at grant is treated as deferred compensation and taxed punitively. Treasury regulation 1.409A-1 requires that the exercise price “may never be less than the fair market value of the underlying stock” on the grant date. Since private stock has no market price, companies buy a valuation.

Two safe harbours matter. An independent appraisal meeting the standards of section 401(a)(28)(C) is “presumed to result in a reasonable valuation” if it is made “as of a date that is no more than 12 months before the relevant transaction,” which is the origin of the annual 409A refresh cycle. The Commissioner can rebut that presumption only by showing the method or its application was “grossly unreasonable.”

A second, illiquid start-up safe harbour applies where the company has conducted no material trade or business for 10 years or more, has no publicly traded class of equity, and the valuation is “made reasonably and in good faith and evidenced by a written report.” It is unavailable if a change of control is reasonably anticipated within 90 days of the valuation, or a public offering within 180 days.

The practical consequence for an employee: ask for the current 409A price and the date it was set, because the spread between that price and the strike price on the grant is the entire tax planning problem.

Cliffs, early exercise and the 30-day clock

The standard private-company vesting schedule is four years with a one-year cliff: nothing vests for twelve months, then a quarter vests at once and the remainder monthly or quarterly. The cliff protects the pool from short-tenure hires, and it means an employee who leaves at month eleven has nothing.

Early exercise, where a plan allows an employee to buy unvested shares subject to a repurchase right, is the most powerful tool available and the most time-limited. Buying at or near a low 409A price means almost no spread, so no ordinary income and no AMT exposure, and the capital gains holding clock starts immediately. Because the shares are subject to a substantial risk of forfeiture, the employee must make a section 83(b) election to be taxed now on the small spread rather than later on the large one.

The deadline is unforgiving. The IRS Form 15620 instructions state that “an 83(b) election must be filed no later than 30 days after the date the property was transferred,” and that the election “may not be revoked except with the consent of the IRS.” Thirty days from transfer, not from an offer letter, not from a start date. Missing it converts a clean capital gains position into ordinary income on the full appreciation at every vesting date.

Exercise windows, where most employee equity dies

The default post-termination exercise window in most plans is 90 days. That number is not arbitrary: section 422 requires continuous employment until three months before exercise for a grant to keep ISO treatment, so a plan that lets employees exercise later loses ISO status on those shares and converts them to NSOs.

The result is a squeeze. An employee leaving a company whose 409A price has risen tenfold has 90 days to find the exercise cost plus the tax on the spread, on shares they cannot sell. Most people cannot, and the options lapse back into the pool. A minority of companies extend the window well beyond three months, accepting the conversion to NSO treatment rather than quietly clawing back earned compensation. Whether a plan does this is among the most financially significant facts about a grant, and it is rarely in the offer letter. Ask.

Canada does this differently, and mostly better

Canadian employees of Canadian startups have a structurally better deal, and it turns on one distinction. Under the Canada Revenue Agency’s rules on employee security options, the taxable benefit is the fair market value of the securities when acquired, less what the employee paid for them, less anything paid to acquire the option itself. When that benefit is taxed depends on the employer:

• Non-CCPC employers: the benefit is included in income in the taxation year the employee acquired the shares. Same timing problem as the United States.
• CCPC employers: the benefit is included in income in the taxation year the employee disposed of the shares. The tax follows the cash.

That deferral is the single most founder-friendly feature of Canadian equity compensation. An employee of a Canadian-controlled private corporation can exercise cheaply, hold, and pay nothing until a sale actually happens, which removes the exercise-and-owe trap that empties option pools in the US.

On top of the deferral there is the security options deduction under paragraphs 110(1)(d) and 110(1)(d.1). Where the conditions are met, including that the option price was not below fair market value at the date of the agreement and that the employee dealt at arm’s length with the employer, the employee deducts 50% of the qualifying benefit, which produces an effective rate comparable to a capital gain. The reduction of that deduction to one-third, proposed alongside the change to the capital gains inclusion rate, was announced as not proceeding on 21 March 2025, so 50% is the rate as of 2026. Employees claim it on line 24900 of the T1 return, using Form T1212 where a benefit was previously deferred.

One limit applies to large employers. For non-CCPCs with revenues over $500 million, options granted on or after 1 July 2021 are subject to a $200,000 annual vesting limit. Securities above that limit in a given vesting year are deemed non-qualified, and the benefit on them does not attract the 50% deduction at all.

The five questions to ask before you sign an offer

1. How many shares, and out of how many fully diluted? A share count without a denominator is not information.
2. What is the current 409A price, or the current fair market value, and when was it set? This determines your strike price and your exercise cost.
3. Does the plan permit early exercise? If it does, calendar the 83(b) deadline the day you exercise, because you have 30 days and no extensions.
4. What is the post-termination exercise window? Ninety days and a high strike price is a grant that may never pay you anything.
5. Are we a CCPC, and are we likely to stay one? For Canadian employees this changes the timing of the entire tax bill, and control shifting to non-resident investors can end it.

None of this is advice specific to your situation, and an hour with an accountant before you exercise is cheap relative to what is at stake. But an employee who can answer those five questions is negotiating from a much better position than one comparing share counts.

Sources

• Internal Revenue Service — Topic no. 427, Stock options
• Internal Revenue Service — Publication 5992, Equity (Stock) Based Compensation Audit Techniques Guide (PDF)
• 26 U.S. Code § 422 — Incentive stock options (Cornell LII)
• 26 CFR § 1.409A-1 — Definitions and covered plans (Cornell LII)
• Internal Revenue Service — Form 15620, Section 83(b) Election (PDF)
• Canada Revenue Agency — Employee security (stock) options
• Canada Revenue Agency — Line 24900, Security options deductions
• Canada Revenue Agency — Type of corporation (CCPC definition)