I don't see a world where you have to pay lots of taxes for worthless options, unless someone really screwed-up (i.e. messed up the 409 Safe Harbor election etc...)
Now... if you exercise the option, that is a different story. At least in theory you would only exercise if things went well and the stock went up vs the strike, which makes sense why one would have to pay taxes then.
You exercise if you leave, and startup IPOs can take many years, and most startups don't have a compelling options package for you after the first 4 years anyway.
So a senior engineer who got their full 4 year equity and wants to leave, which is the most typical scenario, will indeed have to exercise and get hit by the tax bill.
If you worked at a startup (not a small business), the most likely outcomes after 4 years is either 1) Company went bust, 2) Company grew.
The option protects you from the not having to pay anything if scenario #1 happens. If scenario #2 happens, then you should be happy: you have an option to pay X for something that is usually worth multiples of X after 4 years.
I actually think the IRS is being nice not to tax the at-the-money option grant. They essentially assume zero time value, which would be quite high for a startup given the high volatility and the potentially long term for the option.
Options are a cost, often in the 5 to 6 figures range to exercise. If you exercise at time of hire, your cost can be significant for something that will probably perform less than putting it into bitcoin as far as expected value goes. If you count exercise cost as part of the 'salary', then startup salary is even worse than it usually is.
When you leave, the options expire away typically after 90 days. If you exercise, even if they are ISOs, AMT tax can easily make the exercise cost 6 figures anyway. Most engineers in their mid 20s do not have 6 figures in savings unless they already worked at FANG for the first 4 or 5 years of their career. You have to choose, do i put most of my savings into something that will probably go nowhere? Most do not and lose out on the significant compensation they would of at FANG. It's a system that favors the already wealthy and young adults with wealthy parents.
Companies actively try to prevent giving liquidity to employees through restrictive clauses. The best case scenario is an employee that works hard and then forfeits their equity due to the above math. The company has a financial incentive to screw employees over and seduce them with unlikely projections of life changing wealth.
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On the other hand, founders have stock at the start, valued at $0. Even if they have a vesting schedule, they can pre-exercise for no cost. Since it's extremely unlikely that they will sell in the first year, all of their income from that stock in the future will be taxed at LTCG rates. Since the average employee can't afford to pre-exercise (or they get RSUs), they pay at income tax rates, so if they do get lucky, they've compressed 4-8 years of equity compensation in one year, which means they pay %25-%35 more in income tax alone. Employees are often subject to 6 month lockups after IPO, which means if it drops, they have to pay tax on a value that is much higher than they can liquidate with the stock they actually have.
Founders often get special liquidity access that employees don't, in secret, during funding rounds. VCs do this to align the founder's interests with theirs, which is going for an outlier $10B IPO vs. liquidate at $300 million at series B, because if the founder has %20, that is a life changing $60 million, taxed at LTCG rates, that makes you an ultra high net worth individual, but is basically a failure from the VCs perspective.
Right, so the bottom line is this:
After 4 years working at the startup, unless it already went bust, you will typically want to exercise, and then you'll get hit by a big tax bill for purchasing a security which is still very likely to end up at zero.
It's a risk no matter how you look at it. Unless you happen to work at a startup that became a unicorn, which is very rare, you will end up paying good money for something that may be entirely worthless.
So in the best case scenario, you take a risk for an upside that may put your comp around the same level as what you'd get for simply working for FAANG. Worst case, you pay a big tax bill that drops your comp even farther below what your friends at FAANG are making, which is already going to be twice or more to begin with.
Surely you see the problem here, especially for risk-averse engineers.
If the plan is to completely give up on my equity, why work at a startup at all?
The fact that one would receive significantly less salary compensation vs FAANG has nothing to do with taxes or startups really, it's just plain and bad decision making. If one is going to get a salary cut, one should make a rough analysis valuing the options/stocks adjusted for the few scenarios and compare.
Plus, 95%+ of Engineers (senior or not) don't get into FAANG, so the generalization is not appropriate.
In practice, most people assume the value the equity and options to zero, and always assume it is cherry on top. If you value the stock at zero and get a massive pay cut, then it's just a bad decision.
No need to throw the baby out with the bath water.
Technically, it also makes the grant neutral from the value perspective. They’re giving you something worth $X, and asking you to pay $X for it. Why exactly should you value it more than $0 then? Maybe for the optionality, but ATM option just isn’t worth that much...
In that way you minimize any tax risks and at the same time you test how much the company is interested in you and values their employees.
1. Usually there is no liquid market, so for lack of a better term, the valuation is made up.
2. Related to point one, with no liquid market, there is no option to sell the options the raise the money to pay the taxes.
3. There are often restrictions (e.g. lockup periods) that legally restrict you for selling from a specific period. You are forced to take on the risk that the stock doesn't crash, often with much less info or freedom than investors and execs.
In fact, in the US, normally startup options are ISOs (incentive stock options) so theoretically they are NOT taxed on exercise. The issue is that AMT (google it) actually nullifies that ISO tax benefit in most instances, and AMT only has stuck around because Congress can not function to deliver reasonable tax policy.
The main issue with option is the lack of liquidity.
One may have to put down quite a bit of cash down in order to exercise, and that is a problem, even if in practice, it is usually good value for the option holder.
But most people either 1) do not have a lot of cash on hand, or 2) do not have the appetite to tie their hard-earned cash to anything illiquid-that-maybe-could-go-to-zero.
That simply isn't competitive with big established companies like FAANG that offer me $400k+, far better career growth prospects, and far lower risk.
For most startups, the equity will be worthless, and the whole company will either shut down or get acquired, which means you won't have a straightforward career path no matter how hard you work and how many impressive accomplishments you achieve. Meanwhile your friends over at FAANG will be earning twice as much and climbing the promotion ladder simply for doing a good job.
Finally, let's not forget the abhorrent tax treatment that screws you, especially as a senior engineer: while your options will likely end up worthless, you'll have to pay tax for them as if they're worth their weight in gold. That puts a whole new level of risk on the already bad and risky deal of working at startups.
It's beyond me how that tax treatment was allowed to continue given how bad it is for startups, and how much it advantages big established companies that are already deep in anti-trust territory, though I guess that could also be the answer to why it's still the rule.