It’s a familiar startup story: a founder promises a new hire stock or options – maybe in an offer letter or over coffee – but the formal grant never materializes. I’ve seen this scenario many times, and the reasons vary:
- Informal Operations: Early-stage startups operate informally, allowing equity promises to slip through the cracks.
- Not Ready to Issue Equity: The company isn’t ready to issue stock yet—perhaps no equity compensation plan is in place.
- Mistakes in Issuance: In other cases, a mistake derails the grant (quoting the wrong exercise price on a stock option, failing to get board approval, or misnaming the entity).
- Regulatory Roadblocks: There are legal or regulatory restrictions on who can hold stock or membership units.
Whatever the reason, the result is the same: the “promised” equity remains unissued – a mere handshake deal rather than a binding grant.
It’s more common than you might think—I’ve seen it both in big law firms and in boutique firms. Founders get laser-focused on product and growth, and paperwork (like option grants or board approvals) falls to the back burner. But a promised option that never materializes becomes a dispute or tax problem (or both) waiting to happen. And the longer you wait (especially if your company’s valuation is rising), the worse it gets. Delays can slash an employee’s after-tax return by 50%!
Delayed Restricted Stock Awards (C-Corps): The Tax Time Bomb
If the promise involves a Restricted Stock Award (RSA) – actual shares subject to vesting – the stakes are especially high. A delay or poor documentation can trigger serious tax problems for both the company and the employee. By default, stock awards to employees are taxed when they vest, not when they’re granted. With a typical 4-year vesting schedule, the employee owes tax on 25% of the shares in each year as they vest, based on the stock’s value at that time.
This setup is a ticking tax bomb. If the company’s value grows quickly, the tax bill by year four can skyrocket. Not surprisingly, startups typically address this issue upfront.
Section 83(b) to the Rescue: Employees and founders routinely file a Section 83(b) election to pay tax on the entire stock grant right when it’s issued (when the value is lowest) instead of being taxed when shares vest. But this strategy only works if stock is issued and the 83(b) form is filed within 30 days of the grant. If the company drags its feet on issuing the RSA (or the employee misses that 30-day window), the stock will be taxed later. Eventually the value might jump so high that an RSA becomes impractical because it would trigger a massive tax liability.
A Costly Example: Imagine an employee in California with a $100k salary is promised stock that originally was merely nominal but is now worth $100k. If that stock is taxed as ordinary income, at that income level, the combined federal + state tax hit would be around 46%. If the company tries to help by covering the withholding tax of about $46k, that payment becomes additional taxable income too – the company might end up paying roughly $85k in tax all because a stock grant was handled late!
Not surprisingly, if this upfront tax burden is too steep, companies often pivot to another approach.
C-Corp Solutions: Stock Options and RSUs
How can a C-corporation make good on a promised grant when an RSA is no longer practical? Options and RSUs are two common fixes:
- Stock Option Grants: An option gives an employee the right to buy shares in the future at a fixed “exercise” price. To avoid tax complications (the Section 409A rules), the exercise price must be at least the current fair market value of the stock. The employee isn’t taxed when the option is granted, only later if they exercise (buy the shares). This means a company can grant an option late and even adjust or waive vesting to make up for lost time – all without immediate tax consequences.
Downside: If the company’s value (409A valuation) has increased since the promise, the option’s exercise price will be higher. A higher strike price makes it more expensive for the employee to exercise and limits the employee’s upside. Any gain when an option is exercised is taxed as compensation income, not capital gain and the option fails to qualify for QSBS (more on QSBS later).
- Restricted Stock Units (RSUs): If the company’s valuation has climbed so high that stock options would have an exorbitant strike price, an RSU is an attractive alternative. An RSU is essentially a promise to deliver stock in the future when certain conditions are met. In private companies, the typical RSU has a double-trigger: (i) the employee must satisfy time-based vesting (e.g. work 4 years with a one-year cliff) and (ii) a liquidity event (sale of the company, IPO, etc.). The stock isn’t issued (and no taxes are due) until both triggers are met.
RSUs let companies defer the tax event until there’s cash on hand to pay it. Unlike options, RSUs have no exercise price. They’re especially useful when a company’s valuation is high or future growth is uncertain. For example, if a company sells for $1 per share, an employee who has stock options with a $0.60 strike only nets $0.40 per share, whereas an RSU holder gets the full $1 per share.
Downside: To comply with tax deferral rules, an RSU must have an expiration date, typically 7 years. If the company has no liquidity event (sale or IPO) within 7 years, the employee loses the RSUs. This makes RSUs worse than options because stock options typically have a longer term—10 years—and employees can exercise a vested option before it expires. Like options, RSUs are taxed as ordinary compensation income (not capital gains) and don’t qualify for QSBS.
Profit Interests: The LLC Alternative
What if your company is an LLC taxed as a partnership? LLCs have their own tool: profit interests. A profit interest gives the holder a share in the company’s future profits and any increase in value after they receive the interest, without giving them a piece of any current value. (In other words, if the pie grows, they get a slice of that growth, but not the existing pie.) Profit interests can be voting or non-voting.
The appeal of profit interests is their tax advantage and flexibility: a profit interest isn’t taxed when it’s granted. The holder only pays tax when they sell their interest. (One catch: to keep this favorable treatment, the recipient generally must hold the interest for at least 2 years – selling sooner can trigger complications.) Profit interests let employees share in the company’s growth without an upfront tax bill. As the company grows, they’ll pay tax on their share of any current profits (like any LLC member would), but the big payday when the company is sold should qualify as long-term capital gain.
However, there’s a practical wrinkle: someone who holds a profit interest can’t remain a traditional W-2 employee of that LLC. A common workaround is to set up a separate upper-tier entity to issue the profit interests.
If your company is already valuable, profit interests can be an ideal way to grant upside to key people. The recipients aren’t taxed at grant, and if all goes well, their gain will be taxed at favorable capital gains rates.
Note: S-corporations cannot issue profit interests directly. However, an S-corp can do a tax-free restructuring to allow the operating company to issue profit interests.
QSBS vs. Profit Interests: Weighing the Tax Benefits
Profit interests have great tax perks but they can’t offer the Qualified Small Business Stock (QSBS) exclusion. QSBS is a game-changer for startup founders and early employees. If you hold qualified C-corp stock for more than 5 years, you can potentially exclude 100% of the gain on the sale of that stock, up to a $10 million gain (or 10× your investment, whichever is greater). In other words, QSBS can make the first $10 million (or more) of your stock proceeds tax-free at the federal level. (Some states, like California, don’t honor QSBS, while others, like New York, provide QSBS benefits.)
QSBS creates a huge incentive to operate as a C-corporation and to give actual stock (e.g. founder stock or early restricted stock grants) to people early on, starting that 5-year clock ticking. In contrast, if your company is an LLC (taxed as a partnership), none of its equity qualifies for QSBS. If an LLC is sold, the members pay tax on their gains (typically long-term capital gains if held >1 year) with no special exclusion. From an exit-tax perspective, QSBS delivers a far better after-tax outcome.
To summarize how different equity awards are taxed and whether they can get QSBS treatment:
Conclusion
Promised-but-unissued equity awards present challenges, but with proactive communication and thoughtful planning, companies can clean up the mess. Whether you resolve it by granting stock options, making a retroactive stock issuance, using RSUs, or turning to alternative forms like profit interests, the goal is the same: honor your commitments while balancing the legal, tax, and business considerations. This will foster trust, retain talent, and keep your team’s incentives aligned with the company’s long-term success.
