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Warrants vs. Options: Legalities and Tax Implications for Startups

Updated: Oct 25, 2023

Stock options and stock warrants are similar in many ways. Both provide the right to buy a company’s stock for a certain period and at a fixed price, as specified in a contractual agreement. But these instruments are used in different circumstances.


Stock options are usually part of an overall compensation package offered to employees or consultants, whereas warrants are an instrument to entice and reward investors.


Warrants and stock options are structured differently. Unlike warrants, compensatory stock options typically are granted under an equity incentive plan, and they are governed by a vesting scheme. There is also a profound difference in the way warrants and stock options are taxed.


Taxes on Startup Warrants and Stock Options

Warrants as compensation

Warrants typically are issued to investors, but it’s not illegal to receive one as compensation for your services. Realize, though, that you will likely be taxed in the same way as if you had received a stock option


If a warrant is received as compensation, consider the following:

  1. The warrant should have an exercise price equal to the fair market value of the underlying stock on the date of grant in order to avoid additional taxes under Section 409A.

  2. When the warrant is exercised, the excess of the fair market value of the shares received over the exercise price is taxed the same way as regular income.

  3. If you’re an employee, you will need to withhold income and employment tax upon exercise.

  4. If you’re an independent contractor and not an employee, you would not need to withhold income and employment tax, but you would need to report it to the IRS, using Form 1099.

Investment warrants

An investor won’t be taxed as described above as long as the warrant is received as an incentive to make an investment and not as compensation for services provided.


This doesn’t mean, though, that you never owe taxes on warrants. If a warrant is issued, for example, as part of a note, there’s usually an original issue discount that needs to be accounted for as income over the term of the note.


If you’ve received a warrant related to an investment, your best bet is to consult with a tax advisor to make sure you understand all the tax implications.

 

Every startup will eventually need legal counsel — it’s part of doing business. From setting up your organization to managing sales contracts, finding the right lawyer is key.


We break down the best practices for picking a lawyer in our post: The Startup’s Guide to Hiring a Lawyer.


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