You start with an idea, build out the skeleton of a company and before you can afford to pay significant salaries, you start incentivizing the smartest people you know to join you by offering them a piece of the future wealth via equity compensation. There are so many decisions to be made, meetings to take, minimum viable products to roadmap and develop, marketing materials to distribute and no time to waste; as a result, tax consequences of equity grants barely make a founder’s list of “99 problems”. Unfortunately, this oversight could cost your company investor money and IRS attention that could derail your venture before it even gets to additional funding rounds. Having an idea of what to consider when granting equity will save you time and money as the company grows.
Equity in General
In very general terms, there are two main types of equity awards: stock grants (which for purposes of this article includes restricted stock, restricted stock units, phantom stock and performance awards) and stock options, which give an employee the opportunity to purchase company stock in the future at a price determined as of the date of the grant. Not only do the tax implications differ based on the type of equity award you choose, but the advantages and disadvantages of each type of award will depend on the business needs of your company.
Now, the tax concerns we’re discussing here applies to stock grants or options that are awarded to employees. If the employee buys the stock directly from the company, then there is no taxable transaction at the point of purchase. As a company matures and grows in value, this is often not a practical course of action where the purchase price would be economically prohibitive. However, at the time of founding, stock is practically worth nothing, or not more than the par value of the stock (i.e. the legal minimum that a single share of stock can be sold, usually a fraction of a cent, for instance $0.0001 per share). Accordingly, it is seen as a best practice among many legal practitioners to sell founders stock at the par value; founders contribute a nominal amount of cash (maybe $100 for 1,000,000 shares at $0.0001 per share par value). This provides a founder with enough initial shares to properly handle necessary dilution, all without breaking the bank, and without incurring unintended tax consequences down the road.
Tax Basics
For federal income tax purposes, remember that when looking at reportable gross income, the IRS includes “all income from whatever source derived [and includes…] compensation for services”. By default, this would capture all equity-based awards, both stock grants and stock options.
The tax implications of stock grants make them less ideal for an early stage company, at least to the extent that the stock has any underlying value. An employee will owe taxes for the tax year in which the stock was granted (or if the grant is subject to vesting, then for the tax year when vesting occurs), based on the fair market value of that stock. See below regarding discussion of the 83(b) election, which modifies this analysis a bit. The employer is required to withhold and remit payroll taxes and include that compensation on the employee’s W-2. An employee will owe taxes on their stock regardless of whether they have the cash on hand to pay the taxes (and most often they can even sell the shares to cover the tax)!
More commonly, companies will choose to grant stock options. Under the Internal Revenue Code (IRC), the IRS has granted special tax deferred treatment to particular classes of stock options. These allow for a company to grants options to employees and defer payment of any taxes until certain events in the future. There are two classifications of options that are relevant to this discussion: incentive stock options (ISO) and nonqualified stock options (NQO). When we refer to the “FMV”, we mean “fair market value”. When we say “spread” we mean the positive difference between the exercise price and the current FMV at the time of exercise (e.g. a $1.00 per share exercise compared to a $3.50 FMV results in a spread of $2.50 per share – this spread is income).
Avoiding Negative Tax Treatment
ISOs:
- Eligibility: Employees only
- Taxes:
- If priced at or above FMV at grant, not taxable upon receipt or vesting
- Upon exercise, spread not recognized for income tax liability, and is not deductible as an expense by the company. Note that option income resulting from the spread it taken into account when determining AMT (Alternative Minimum Tax) liability, if any
- Upon sale, long-term capital gains treatment IF i) held stock for 1 year after exercise AND ii) for at least 2 years after grant of option (must meet both measures)
- Monetary Limitation:
- Only up to $100K in stock underlying ISO exercisable in any calendar year
- Options to greater than 10% shareholders must be priced at least 110% of FMV and not exercisable after expiration of 5 years from grant date
- AMT: Applicable to the spread on exercise
NQOs:
- Eligibility: Employees and independent contractors
- Taxes:
- If priced at or above FMV at grant, not taxable upon receipt or vesting
- Upon exercise, the spread is taxed as ordinary income and subject to income and employment tax withholding (note, that if exercised when the exercise is still equal to the FMV, the net result is no tax liability)
- Upon sale, long-term capital gains if held for 1 year after exercise.
- Monetary Limitation: None
- AMT: Not applicable
Overall, NQOs are simpler, have no AMT consequences and no annual limitations. In addition, the spread on the exercise of NQOs is deductible to the employer. The primary appeal of ISOs, is potentially very favorable tax treatment for employees (being able to defer taxes all the way to an eventual sale of the stock acquired by exercising options), however, employees often exercise their options during a liquidity event (when they have the money to exercise) and do not qualify under the holding requirements for long term capital gains treatment. As you can see, the decision of how to compensate employees and contractors is fact-specific, and you will serve your growing company well by paying careful attention to the implications of these decisions in the long run.
83(b) – A Tax Planning Tool
With respect to any of the equity grants discussed in this article, if taxes are due, they are generally due when the award vests, meaning, in the eyes of the IRS they are no longer at “substantial risk of forfeiture” (in simple terms, if the employee or contractor leaves the company, all unvested stock or options are typically surrendered without any further compensation). For an eventual long-term capital gain analysis, the holding period also tracks along with vesting, meaning that an award holder would only get long term capital gains treatment for those awards which have vested and have been held for at least one year. For awards with vesting that stretches out 48 months or longer, this all but eliminates the ability to treat gains as long term capital gains following a sale of a company. To address this problem, an election can be made under Section 83(b) the IRC by which an award holder pays all taxes on the grant up front, disregarding the vesting. This election applies only to awards that are subject to vesting. Upon filing an 83(b) election (which must be done within 30 days of the date of exercise), the holding period for long-term capital gains starts as of the date of exercise with respect to the entire grant! In an exit scenario, this can significantly increase the cash retained by the individual. Of course, there are two sides to every coin: there is an inherent risk that if the award holder leaves the company, the unvested stock or options are surrendered, with the tax having already been paid, and there is no refund or credit against taxes in that scenario. Many people feel that the potential upside far outweighs the risk. If you are in this position, you should consult your tax advisor for guidance.
This post is provided for general information purposes and is not legal advice. As always, if you have any questions about this post or how it might impact your business, contact one of our attorneys.