[jlmorton]

> Capital gains would not be recognized if you exercised the options and held onto the shares.

That's not exactly accurate in the US. You need to pay income tax - not capital gains - on the spread between the strike price and the fair market value. Since the company is not publicly traded, the fair market value needs to be assessed. The IRS has rules on how to do this, but many companies use independent third party auditors to do this, though an early stage company probably would not do this.

Once an investment has been made, a fair market value has been established, and you need to report the difference between the strike price and the investment price as income when you exercise options. Capital gains applies when you later sell the stock for a gain.

Edit: Though I should point out, this is only for non-qualified stock options. If the options are tied to performance metrics, for instance, this may not apply.

Edit 2: See here for a discussion of this: http://www.investopedia.com/articles/optioninvestor/07/esoab...

[emcrazyone]

he can't pay income tax if he's never received the income.

"I will be left with a tax bill on $10,000s of additional "income" that I never received"

[davidu]

Actually, and unfortunately, in the US, that's how it works.

His paper gains are taxed. It's not quite "income" but it's taxed that way.

[limeyx]

That actually depends on if the options were ISO's (where you'd only have to account for the spread in AMT calculations) or non-Quals where yes you'd have to pay regular tax on the spread at exercise time.

If he's really a founding engineer though he should have filed an IRS 83B election and basically paid close to zero tax on all this

[davidu]

Correct.