Tax basics of equity compensation
Start-ups often do not have sufficient cash to pay their employees a market salary. To attract these valuable resources, companies turned to various forms of equity awards to bridge the pay gap. These noncash compensation strategies can be an excellent win-win if structured correctly. Employers are able to attract and retain key employees while also giving their talent the opportunity to invest in the company’s growth and success.
There are several types of equity awards a start-up operating as a corporation could consider, and each has its own tax consequences.
Stock options
Stock options were arguably the earliest form of equity compensation and primarily include incentive stock options (ISOs) and nonqualified stock options (NSOs). The major difference between the two is their federal tax treatment.
Incentive stock options
ISOs, also known as statutory options, are subject to strict rules under the Internal Revenue Code and can only be granted to employees of the issuer. Once granted, and upon vesting of an ISO, there are no tax consequences to the employer or the employee.
There is generally no tax impact either when the employee exercises the options, though the bargain element of the stock (i.e., the spread between the fair market value and exercise price) can result in alternative minimum tax liability. In order to reap the favorable tax benefits of an ISO, the employee cannot sell the stock within two years from the grant date or within one year of the exercise date.
If the required holding period is met, the only tax consequence for the employee will be capital gains, which is based on the difference between the employee’s exercise price and the price at which the stock was sold. However, if the stock is sold prior to the expiration of the holding period, its sale is considered a disqualifying disposition and the bargain element will be taxed to the employee as compensation at ordinary income tax rates.
These awards are often used by founders early in a company’s lifecycle due to valuation considerations and the desire to encourage key employee tenure early on.
Nonqualified stock options
Unlike ISOs, NSOs can be awarded to both employees and independent contractors. This can be an attractive feature for cash-sensitive start-ups that need to pay advisors and consultants.
The significant tax difference between the two types of stock options is that NSOs are taxed once they are exercised. Specifically, when NSOs are exercised, the bargain element of the shares is taxed as compensation income to the recipient and is deductible by the employer.
These are usually issued to rank-and-file employees and/or consultants and can be awarded at any stage of company growth.
Restricted shares
Employers may also want to consider awarding restricted stock rather than options to employees. The two variants to consider, restricted stock awards (RSAs) and restricted stock units (RSUs), can both be freely issued to independent contractors.
Restricted stock awards
An RSA is a transfer of an employer’s stock that is subject to vesting requirements and includes the employer’s right to repurchase the shares during the vesting schedule. These characteristics prevent an employee from receiving shares and leaving the company immediately thereafter.
RSAs can be issued at no cost to the employee—at the stock’s current price or at a discount—which makes RSAs an attractive form of equity compensation when the employer’s stock value is minimal and is expected to increase.
RSAs are taxed to the employee when vesting occurs based on the difference between the value of the stock at the time it vests and the price the employee paid for such stock. Similar to options, this spread is taxed as compensation income at ordinary rates and the employee will be subject to capital gains when the shares are ultimately sold. The employer is generally entitled to a deduction for the year in which the employee is taxed on the spread.
These are often reserved for founders or key executives in the early stages of a company’s lifecycle when valuations are low.
Restricted stock units
An RSU gives the recipient the right to receive a transfer of the employer’s stock at a future date or a transfer of a cash equivalent, subject to vesting requirements. If the units are settled in stock, the employee recognizes ordinary income based on the fair market value of the shares on the date of transfer. There would then be capital gain or loss treatment upon selling the stock. If the units are settled in cash, the employee must recognize ordinary income in the taxable year the cash payment is actually or constructively received. Similarly, the employer is entitled to a compensation deduction in the same year.
These are usually issued to rank-and-file employees and/or consultants at any stage of company growth.
The Section 83(b) election
Elections under Section 83(b) are well-known in the world of equity compensation. Note that the election can only be made when property is transferred to an employee as compensation. Therefore, stock options and RSUs are not eligible awards for an 83(b) election.
The election allows an employee to recognize ordinary income on the grant date of the unvested restricted shares. The upside is that it starts the clock on the holding period for capital gains treatment.
Example. Assume Employee is granted 100,000 restricted shares by Company with a value of $.01 per share. Two years later, Company sells to private equity for $50 a share (all restrictions lapse due to the transaction). If Employee makes an 83(b) election, they’ll recognize $1,000 of taxable income and pay ordinary income tax on that amount in the year of grant. Upon the sale of Company, Employee will have capital gains of $4,999,000 ($5,000,000 less basis of $1,000). The net tax on these on the sale would be approximately $1,195,000
If Employee makes no 83(b) election, no income is recognized on grant, but upon the sale of Company, the entire $5,000,000 of proceeds would be taxed as ordinary income. The net tax in this case would be approximately $2,000,000.
The decision to make an 83(b) election is an important one that must be thoroughly analyzed. As the example above highlights, the impact of failing to make the 83(b) election can be significant. The election itself must be made within 30 days of the transfer and once made, can be revoked only in very limited circumstances.
If you’re an employee receiving equity-based compensation, or you’re considering implementing an equity plan, let’s talk. Contact your CLA advisor to discuss how these plans may impact you and your organization.
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