A Guide to Equity Compensation and Tax Implications for Startup Employees

Published: February 28, 2024 • Contractors & Employees, M&A

Introduction

Equity compensation is a common way for startups to attract and retain talented employees. By granting employees an ownership stake in the company, startups can align the interests of employees with those of the company and its investors. However, the tax implications of equity compensation can be complex, and it’s important for startup employees to understand the different types of equity compensation and the associated tax consequences.

In this guide, we’ll explore the various types of equity compensation, including incentive stock options (ISOs), nonqualified stock options (NSOs), restricted stock units (RSUs), and restricted stock awards (RSAs). We’ll also discuss the tax implications of each type of equity compensation and provide strategies for managing the tax impact. Finally, we’ll cover some important considerations for startup employees navigating the complexities of equity compensation.

Types of Equity Compensation

  1. Incentive Stock Options (ISOs)

ISOs are a type of stock option that qualifies for special tax treatment under the Internal Revenue Code. To qualify as an ISO, the option must meet certain requirements, such as:

  • Being granted under a written plan approved by the company’s shareholders
  • Having an exercise price equal to or greater than the fair market value of the stock on the grant date
  • Being exercisable within 10 years from the grant date
  • Being granted to employees only (not contractors or directors)

When an employee exercises an ISO, there is no regular taxable income recognized at the time of exercise. Instead, the difference between the exercise price and the fair market value of the stock at the time of exercise is treated as an adjustment for alternative minimum tax (AMT) purposes.

If the employee holds the stock for more than one year after exercise and two years after the grant date (known as a “qualifying disposition”), any gain on the sale of the stock is taxed as a long-term capital gain. If the employee sells the stock before meeting the holding period requirements (known as a “disqualifying disposition”), the gain is taxed as ordinary income.

Example:

  • An employee is granted 1,000 ISOs with an exercise price of $1 per share when the fair market value of the stock is also $1 per share.
  • One year later, the employee exercises all 1,000 ISOs when the fair market value of the stock is $5 per share.
  • The employee holds the stock for two more years and then sells it for $10 per share.
  • The employee recognizes a long-term capital gain of $9 per share ($10 sale price – $1 exercise price) on the sale of the stock.
  1. Nonqualified Stock Options (NSOs)

NSOs are a type of stock option that does not qualify for the special tax treatment of ISOs. NSOs can be granted to employees, contractors, and directors, and there are no holding period requirements for favorable tax treatment.

When an employee exercises an NSO, the difference between the exercise price and the fair market value of the stock at the time of exercise (known as the “spread”) is taxed as ordinary income, subject to federal income tax withholding, Social Security, and Medicare taxes.

If the employee holds the stock after exercise, any subsequent gain or loss on the sale of the stock is taxed as a capital gain or loss. The capital gain or loss is long-term if the stock is held for more than one year after exercise, and short-term if the stock is held for one year or less.

Example:

  • An employee is granted 1,000 NSOs with an exercise price of $1 per share when the fair market value of the stock is also $1 per share.
  • One year later, the employee exercises all 1,000 NSOs when the fair market value of the stock is $5 per share.
  • The employee recognizes ordinary income of $4,000 ($5 fair market value – $1 exercise price x 1,000 shares) at the time of exercise.
  • The employee holds the stock for six more months and then sells it for $7 per share.
  • The employee recognizes a short-term capital gain of $2 per share ($7 sale price – $5 fair market value at exercise) on the sale of the stock.
  1. Restricted Stock Units (RSUs)

RSUs are a type of equity compensation that represents a promise by the company to deliver shares of stock to the employee at a future date, subject to vesting conditions. RSUs are typically granted to employees at no cost, and the employee does not have any ownership rights in the stock until the RSUs vest.

When RSUs vest, the fair market value of the stock on the vesting date is taxed as ordinary income, subject to federal income tax withholding, Social Security, and Medicare taxes. The company typically withholds shares of stock to cover the tax liability, and the employee receives the remaining shares.

If the employee sells the stock after vesting, any subsequent gain or loss on the sale is taxed as a capital gain or loss, depending on the holding period.

Example:

  • An employee is granted 1,000 RSUs that vest over four years, with 25% vesting each year.
  • On the first vesting date, 250 RSUs vest when the fair market value of the stock is $10 per share.
  • The employee recognizes ordinary income of $2,500 ($10 fair market value x 250 shares) on the vesting date.
  • The company withholds 75 shares to cover the tax liability, and the employee receives 175 shares.
  • The employee holds the stock for two more years and then sells it for $20 per share.
  • The employee recognizes a long-term capital gain of $10 per share ($20 sale price – $10 fair market value at vesting) on the sale of the stock.
  1. Restricted Stock Awards (RSAs)

RSAs are a type of equity compensation that involves the grant of stock to an employee, subject to vesting conditions. Unlike RSUs, the employee has immediate ownership rights in the stock, including the right to vote the shares and receive dividends.

Under Section 83(b) of the Internal Revenue Code, an employee can elect to be taxed on the fair market value of the stock at the time of grant, rather than at the time of vesting. If the employee makes a Section 83(b) election, any subsequent gain or loss on the sale of the stock is taxed as a capital gain or loss, depending on the holding period.

If the employee does not make a Section 83(b) election, the fair market value of the stock on the vesting date is taxed as ordinary income, subject to federal income tax withholding, Social Security, and Medicare taxes.

Example (with 83(b) election):

  • An employee is granted 1,000 RSAs that vest over four years, with 25% vesting each year.
  • The fair market value of the stock at the time of grant is $1 per share.
  • The employee makes a Section 83(b) election and recognizes ordinary income of $1,000 ($1 fair market value x 1,000 shares) at the time of grant.
  • The employee holds the stock for four years until it is fully vested, and then sells it for $10 per share.
  • The employee recognizes a long-term capital gain of $9 per share ($10 sale price – $1 fair market value at grant) on the sale of the stock.

Example (without 83(b) election):

  • An employee is granted 1,000 RSAs that vest over four years, with 25% vesting each year.
  • On the first vesting date, 250 RSAs vest when the fair market value of the stock is $5 per share.
  • The employee recognizes ordinary income of $1,250 ($5 fair market value x 250 shares) on the vesting date.
  • The employee holds the stock for two more years and then sells it for $10 per share.
  • The employee recognizes a long-term capital gain of $5 per share ($10 sale price – $5 fair market value at vesting) on the sale of the stock.

Tax Planning Strategies

  1. Exercise Early and File an 83(b) Election

For employees who receive ISOs or RSAs, exercising the options or making a Section 83(b) election early can be a tax-efficient strategy. By exercising ISOs early and holding the stock for more than one year, the employee can potentially qualify for long-term capital gains treatment on the sale of the stock. Similarly, by making a Section 83(b) election for RSAs, the employee can potentially pay tax on a lower valuation and qualify for long-term capital gains treatment on the sale of the stock.

However, there are risks to exercising early or making a Section 83(b) election. If the stock price declines after exercise or election, the employee may end up paying more in taxes than if they had waited until vesting to be taxed. Additionally, exercising options or making an 83(b) election requires the employee to pay the exercise price or tax out of pocket, which may not be feasible for everyone.

  1. Manage AMT Liability

Exercising ISOs can trigger AMT liability, which can be a significant tax burden for startup employees. The AMT is a parallel tax system that requires taxpayers to calculate their tax liability under both the regular tax system and the AMT system and pay the higher of the two.

To manage AMT liability, employees can consider exercising ISOs in years when their regular taxable income is low, or spreading out ISO exercises over multiple years to avoid a large AMT bill in any one year. Employees can also consider selling some of the stock in the same year as the ISO exercise to generate cash to pay the AMT liability, although this strategy requires careful planning to ensure that the employee still meets the holding period requirements for favorable tax treatment.

  1. Consider the Timing of RSU Vesting

For employees who receive RSUs, the timing of vesting can have significant tax implications. If RSUs vest in a year when the employee’s taxable income is high, the employee may be pushed into a higher tax bracket and owe more in taxes.

To manage the tax impact of RSU vesting, employees can consider negotiating with their employer to spread out RSU vesting over multiple years, or to grant RSUs in years when the employee’s taxable income is expected to be lower. Employees can also consider selling some of the stock upon vesting to generate cash to pay the tax liability.

  1. Understand the Impact of Short-Swing Profit Rules

Under Section 16 of the Securities Exchange Act of 1934, directors, officers, and 10% shareholders are subject to short-swing profit rules, which require them to disgorge any profits earned from buying and selling company stock within a six-month period.

Employees who become subject to short-swing profit rules should be careful to avoid any transactions that could trigger liability, such as exercising options and selling stock within a six-month period. Employees can also consider filing a Form 4 with the SEC to report any transactions in company stock and avoid inadvertent violations of short-swing profit rules.

  1. Plan for Liquidity Events

Startup employees who receive equity compensation should also plan for potential liquidity events, such as an IPO or acquisition. These events can trigger significant tax liabilities, as well as restrictions on the ability to sell stock.

Employees can consider strategies such as using a 10b5-1 plan to sell stock in a systematic and pre-planned manner, or using a cashless exercise to sell enough stock to cover the tax liability and hold the remaining shares for potential future appreciation.

Navigating the Complexities of Equity Compensation

Equity compensation can be a valuable tool for startups to attract and retain talented employees, but the tax implications can be complex and require careful planning. Employees who receive equity compensation should work closely with their tax advisors and financial planners to understand the different types of equity compensation, the associated tax consequences, and potential planning strategies.

Startup employees should also stay informed about the company’s financial performance and plans for liquidity events, as these can have significant implications for the value of their equity compensation. Employees should carefully review their stock option agreements and grant documents to understand the terms and conditions of their equity compensation, including vesting schedules, exercise prices, and expiration dates.

It’s also important for startup employees to diversify their investments and not rely solely on their equity compensation for long-term wealth building. While equity compensation can be a valuable asset, it’s important to have a balanced portfolio that includes other types of investments, such as mutual funds, bonds, and real estate.

Finally, startup employees should be aware of the potential risks and drawbacks of equity compensation. Equity compensation is often subject to vesting conditions and may not have any value if the company does not achieve a successful exit or liquidity event. Additionally, the value of equity compensation can be difficult to predict and may be subject to market volatility and other factors outside of the employee’s control.

Conclusion

Equity compensation is a complex and nuanced area of tax law, and the rules and regulations are subject to change. Startup employees who receive equity compensation should take the time to educate themselves about the different types of equity compensation, the associated tax implications, and potential planning strategies.

By understanding the complexities of equity compensation and working closely with tax and financial advisors, startup employees can make informed decisions about their equity compensation and build long-term wealth. While equity compensation can be a valuable asset, it’s important to approach it with a balanced and diversified investment strategy, and to be aware of the potential risks and drawbacks.

Ultimately, the key to successfully navigating equity compensation is to stay informed, plan ahead, and seek professional advice when needed. With careful planning and a long-term perspective, startup employees can maximize the value of their equity compensation and achieve their financial goals.