Taxes on Equity Compensation

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Holloway Guide ToEquity Compensation
Common questions covered here
What do I need to know about taxes and equity compensation?
What are the specific tax implications of stock options and awards?
What is a good overview of how equity compensation is taxed?

Taxes on Equity Compensation

Equity and taxes interact in complicated ways, and the tax consequences for an employee receiving restricted stock, stock options, or RSUs are dramatically different. This section will cover these messy details and help you make decisions that reduce the tax burden of your equity compensation.

83(b) Elections

This section covers one of the most important and complex decisions you may need to make regarding stock awards and stock options: paying taxes early with an 83(b) election.

  • Generally, restricted stock is taxed as ordinary income when it vests.
  • If the stock is in a startup with low value, this may not result in high tax. If it’s been years since the stock was first granted and the company is now worth a lot, the taxes owed could be quite significant.

Definition The Internal Revenue Code, in Section 83(b), offers taxpayers receiving equity in exchange for work the option to pay taxes on their options before they vest. If qualified, a person can tell the IRS they prefer this alternative in a process called an 83(b) election. Paying taxes early with an 83(b) election can potentially reduce taxes significantly. If the shares go up in value, the taxes owed at vesting might be far greater than the taxes owed at the time of receipt.

  • confusion Why is it called an election? Because you are electing (choosing) to pay taxes early in exchange for this treatment by the IRS. Does the IRS secretly enjoy making simple concepts sound confusing? We’re not sure.
  • An 83(b) election isn’t guaranteed to reduce your taxes, however. For example, the value of the stock may not increase. And if you leave the company before you vest, you don’t get back the taxes you’ve already paid.
  • danger You must file the 83(b) election yourself with the IRS within 30 days of the grant or exercise, or the opportunity is irrevocably lost.
  • confusion Note an 83(b) election is made on receipt of actual shares of stock. Technically, it cannot be made on the receipt of a stock option itself: You first must exercise that option, then file the election.
  • If you receive an early exercisable stock option (when you don’t have to wait for the the stock to vest), you can make an 83(b) election upon receipt of the exercised shares.
  • Section 83(b) elections do not apply to vested shares; the election only applies to stock that is not yet vested. Thus, if you receive options that are not early exercisable (meaning you have to wait until they vest to exercise), an 83(b) election would not apply.
  • important Founders and very early employees will almost always want to do an 83(b) election upon the receipt of unvested shares, since the stock value is probably low. If the value is really low, and the taxes owed are not that great, you can make the election without having to pay much tax and start your capital gains holding period on the shares.
  • ···

new With the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, Congress approved a new Section 83(i) that is intended to allow deferral of tax until RSU and stock option holders can sell shares to pay the tax bill. Whether companies will choose or be able to make this available to employees is not clear yet.

409A Valuations

When a person’s stock vests, or they exercise an option, the IRS determines the tax that person owes. But if no one is buying and selling stock, as is the case in most startups, then the value of the stock—and thus any tax owed on it—is not obvious.

Definition The fair market value (FMV) of any good or property refers to a price upon which the buyer and seller have agreed, when both parties are willing, knowledgeable, and not under direct pressure to carry out the exchange. The fair market value of a company’s stock refers to the price at which a company will issue stock to its employees, and is used by the IRS to calculate how much tax an employee owes on any equity compensation they receive. The FMV of a company’s stock is determined by the company’s most recent 409A valuation.

Definition A 409A valuation is an assessment private companies are required by the IRS to conduct regarding the value of any equity the company issues or offers to employees. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS won’t consider it reasonable. In order to minimize the risk that a 409A valuation is manipulated to the benefit of the company, companies hire independent firms to perform 409A valuations, typically annually or after events like fundraising.

The 409A valuation of employee equity is usually much less than what investors pay for preferred stock; often, it might be only a third or less of the preferred stock price.

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controversy Although the 409A process is required and completely standard for startups, the practice is a strange mix of formality and complete guesswork. It has been called “quite precise—remarkably inaccurate,” by venture capitalist Bill Gurley. You can read more about its nuances and controversies.

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  • technical “409A” is a reference to the section of the Internal Revenue Code that sets requirements for options to be tax-free on grant.

Taxes on ISOs and NSOs

Typically, early to mid-stage companies grant stock options, which may be ISOs or NSOs.

  • dangerWhen you get stock options and are considering if and when to exercise, you need to think about the taxes and when you owe them. In principle, you need to think about taxes you may incur at three points in time:
    • at time of grant
    • at time of exercise
    • at time of sale
  • These events trigger ordinary tax (high), long-term capital gains (lower), or AMT (possibly high) taxes in different ways for NSOs and ISOs.

Definition The taxes at time of exercise will depend on the gain between the strike price and the FMV, known as the spread or the bargain element.

  • important If you’re granted ISOs or NSOs at a low strike price, and the bargain element is zero, then you may be able to exercise at a reasonable price without triggering taxes at all. So assuming the company allows it, it makes sense to early exercise immediately (buying most or all of the shares, even though they’re not vested yet) and simultaneously file an 83(b) election.
  • caution An 83(b) election, as already discussed, is the choice to be taxed on the receipt of property even though you might have to forfeit or give back the property to the company. You can make an election on the receipt of stock, but you cannot make the election on the receipt of a stock option or an RSU because options and RSUs are not considered property for the purposes of Section 83(b).
  • ···
  • caution ISOs are often preferred by startups, as they’re supposedly better for employees from a tax perspective. This assumes that (1) AMT won’t be triggered and (2) you’ll get a low long-term capital gains rate by holding the stock for the appropriate holding periods. However, often you either run afoul of the AMT trap, or don’t hold the stock long enough with the complicated 1 year + 2 year requirement, or the spread at exercise is small or zero, so the difference wouldn’t matter anyway. NSOs do have a slightly higher tax because of the need to pay employment taxes on NSOs and not ISOs.
  • controversy Overall, it’s not clear the ISO is that much better for employees, so many people argue for NSOs instead.
  • confusion This is partly because ISOs can make it harder to meet the long-term capital gains holding period.* Many people expect early exercise, together with an 83(b) election, will help them hold the stock long enough to qualify for long-term capital gains. While this is true for NSOs, a murky part of the rules on ISOs states that even with an 83(b) election, the capital gains holding period does not begin until the shares actually vest. So if you want to immediately exercise an option and file a Section 83(b) election, and you might have liquidity soon, it’s better—for those who can—to do so with NSOs.

The AMT Trap

When it comes to taxes and equity compensation, one scenario is so dangerous we give it its own section.

danger If you have received an ISO, exercising it may unexpectedly trigger a big AMT bill—even before you actually make any money on a sale! If there is a large spread between the strike price and the 409A valuation, you are potentially on the hook for an enormous tax bill, even if you can’t sell the stock. This has pushed people into bankruptcy. It also caused Congress to grant a one-time forgiveness, the odds of which happening again are very low.

Definition The catastrophic scenario where exercising ISOs triggers a large AMT bill, with no ability to sell the stock to pay taxes, is sometimes called the AMT trap. This infamous problem has trapped many employees and bankrupted people during past dot-com busts. Now more people know about it, but it’s still a significant obstacle to plan around.

new In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), which increases AMT exemptions and their phaseout thresholds. This means fewer people will be affected by AMT in 2018 than in prior years.*

Note that if your AMT applies to events prior to 2008, you’re off the hook.

Understand this topic and talk to a professional if you exercise ISOs. The AMT trap does not apply to NSOs.

Stock Awards vs. ISOs vs. NSOs

Because the differences are so nuanced, what follows is a summary of the taxes on restricted stock awards, ISOs, and NSOs, from an employee’s point of view.

Mary Russell, a lawyer who specializes in equity compensation, recommends each form of equity be used at the appropriate time in private companies: restricted stock awards for the earliest stage of a startup, stock options with longer exercise windows for the early to mid stage, and RSUs for the later stages.*

If you relish tax complexity, you can learn more from:

Taxes on RSUs

If you are awarded RSUs, each unit represents one share of stock that you will be given when the units vest.

  • Here’s the tax summary for RSUs:
    • At grant:
      • No tax
    • At vesting/delivery:
      • Ordinary tax on current share value
    • At sale:
  • caution When you receive your shares, you are taxed on their value at that time.* If you are an employee, this means you may have to write a check to the company to cover your income and employment tax withholding. Often, for U.S. employees, companies will withhold the tax in the form of shares such that no action is required by the employee at vesting time.*
  • If you receive an RSU when the stock is of little value, you cannot elect to be taxed on the value of that stock when you receive the RSU—you pay taxes at vesting time, based on the value of the shares at that time.
  • caution RSUs present some big problems in private companies:
    • You will owe tax when you receive the shares, even though they are illiquid.
    • You can’t minimize the tax impact of an increase in value of the underlying shares between the date you receive the RSU and the date it is settled.
    • If you are an employee you will have to write a check to the company to satisfy your income and employment tax withholding.
  • caution RSUs are less attractive than stock options from a tax point of view because you cannot make an 83(b) election with respect to RSUs. By contrast, if you receive a stock option, as long as it’s priced at fair market value you will have no income upon receipt of the options, and your income tax and employment tax consequences will be deferred until you exercise, an event under your control for the most part.

Tax Comparison Table

This table is a summary of the differences in taxation on types of equity compensation.

Restricted stock awardsISOsNSOsRSUs
Tax at grantIf 83(b) election filed, ordinary tax on FMV. None otherwise.No tax if granted at FMV.No tax if granted at FMV.No tax.
Tax at vestingNone if 83(b) election filed. Ordinary tax on FMV of vested portion otherwise.No tax if granted at FMV.No tax if granted at FMV.Ordinary tax on current share value.
Tax at exerciseAMT tax event on the bargain element. No ordinary or capital gains or employment tax.Ordinary tax on the bargain element. Income and employment tax.
Tax at saleLong-term capital gains tax on gain if held for 1 year past when taken into income. Ordinary tax otherwise (including immediate sale).Long-term capital gains if held for 1 year past exercise and 2 years past grant date. Ordinary tax otherwise (including immediate sale).Long-term capital gains if held for 1 year past exercise. Ordinary tax otherwise (including immediate sale).Long-term capital gains tax on gain if held for 1 year past vesting. Ordinary tax otherwise (including immediate sale).

Tax Dangers

Because they are so important, we list some costly errors to watch out for when it comes to taxes on equity compensation:

  • danger If you are going to file an 83(b) election, it must be within 30 days of stock grant or option exercise. Often, law firms will take a while to send you papers, so you might only have a week or two. If you miss this window, it could potentially have giant tax consequences, and is essentially an irrevocable mistake—it’s one deadline the IRS won’t extend. When you file, get documentation from the post office as well as a delivery confirmation, and include a self-addressed, stamped envelope for the IRS to send you a return receipt. (Some people are so concerned about this they even ask a friend to go with them to the post office as a witness!)
  • danger Watch out for the AMT trap we’ve already discussed.
  • danger If you exercise your options, and your income had been from consulting rather than employment (1099, not W-2), you will be subject to the self-employment tax, which consist of both the employer and the employee side of FICA. In addition to owing the normal income tax, this means you will owe the Social Security tax component (6.2%) up to the FICA wage base, and you will owe the Hospital Insurance component (2.9%) on all of your income.
  • danger Thoughtfully decide when to exercise options. As discussed, if you wait until the company is doing really well, or when you are leaving, the delay can have serious downsides.
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