Income tax is the money paid by individuals to federal, state, and, in some cases, local governments, and includes taxation of ordinary income and capital gains. Generally, U.S. citizens, residents, and some foreigners must file and pay federal income tax.
โimportantโ In general, federal tax applies to many kinds of income. If youโre an employee at a startup, you need to consider four kinds of federal tax, each of which is computed differently.
โconfusionโ When it comes to equity compensation, itโs possible that youโll have to worry about all of these, depending on your situation. Thatโs why we have a lot to cover here:
โDefinitionโ Ordinary income tax is the tax on wages or salary income, and short-term investment income. The term short-term capital gains tax may be applied to taxes on assets sold less than a year from purchase, but profits from these sales are taxed as ordinary income. For a lot of people who make most of their money by working, ordinary income tax is the biggest chunk of tax they pay.
โDefinitionโ Employment taxes are an additional kind of federal tax beyond ordinary income tax, and consist of Social Security and Medicare taxes that are withheld from a personโs paycheck. Employment taxes are also referred to as payroll taxes as they often show up on employee pay stubs. The Social Security wage withholding rate in 2020 is 6.2% up to the FICA wage base of $137,700. The Medicare component is 1.45%, and it does not phase out above the FICA wage base.
โDefinitionโ Long-term capital gains tax is a tax on the sale of assets held longer than a year. Long-term capital gains tax is often lower than ordinary income tax. Many investors hold assets for longer than a year in order to qualify for the lesser tax burden of long-term capital gains.
โDefinitionโ Alternative minimum tax (AMT) is a supplemental income tax that applies to certain individuals in some situations. This type of tax does not come up for many taxpayers, but higher income earners and people in special situations may have to pay large AMT bills. AMT was first enacted in 1979 in response to reports that 155 wealthy individuals had paid no income tax in 1966.* It is not the same as ordinary income tax or employment tax, and is calculated according to its own rules.
โdangerโ AMT is relevant to you if youโre reading this. Itโs important to understand because exercising ISOs can trigger AMT. In some cases a lot of AMT, even when you havenโt sold the stock and have no money to pay. We discuss this later.