Equity compensation can be a great way to reward employees and help the company grow by allowing them to recognize ownership or their stake in the company. However, you may not be aware of the tax implications, especially on stock options and restricted stock awards. So before you get caught surprised by the tax bill, you should understand the tax treatment on different equity compensation types.
In this blog post, we will provide an overview of the possible taxes that may apply to equity compensation based on the governing tax law, and how some people have been mitigating their tax liability on the company’s stock awarded to them.
What are the startup equity tax implications for companies and employees?
Remember that when a startup issues equity to employees, certain tax ramifications apply to both the startup company issuing equity and its early employees. For example, most public and private companies might need to withhold certain taxes on equity compensation such as stock options and restricted stock units (RSUs) paid out to employees.
In addition, a worker may be required to pay taxes on gains your employees realize from appreciating their employee equity. The IRS ruling stipulates that workers owe taxes on their ordinary income and the sale of the vested stock shares. Any equity compensation is considered taxable compensation income, be it stock options or RSUs. For the company, the issuance of startup equity is generally tax-deductible.
Depending on the governing new tax law and the specific type of equity compensation, startup employees may be subject to ordinary income taxes on the difference between the market value of the stock and the exercise or grant price. This can result in a significant tax liability that employees need to plan for and manage accordingly.
To mitigate their tax liability, some startup employees have employed their own tax strategy. For example, they may choose to exercise their stock options when the company's stock value is relatively low to minimize the taxable gain. Alternatively, they may opt for a "cashless exercise" where they sell enough of the stock upon exercise to cover the exercise price and any associated federal taxes.
Depending on the type of equity issued or the number of restricted stock awards, there may be limitations on the deductible amount. For workers, the receipt of employee equity is generally considered taxable compensation income.
Yet, special rules may apply to certain types of equity, such as stock options. As a result, it is important to consult with a tax advisor on making key tax related decisions and to be guided on the tax liabilities of issuing equity or restricted stock awards to employees.
What are the different types of taxes that may apply to startup equity compensation?
For startup equity compensation, three types of taxes may apply: ordinary income tax, capital gains tax, and payroll tax.
Income tax is the most common type of tax, and it applies to both vested and unvested stock options.
Capital gains tax only applies to vested stock options based on the difference between the strike price and the stock's current market value.
Payroll tax is a tax deduction on an employee's paycheck and applies to restricted stock units (RSUs) that have been granted.
The amount of payroll tax due will depend on the employee's marginal tax rate.
What are the common mistakes businesses make when it comes to taxation of equity compensation?
One of the most common mistakes businesses make when it comes to taxation of equity compensation for early stage employees is not understanding the tax consequences of receiving company stock. Employees receiving stock from their employer may be subject to tax on the difference between the stock's fair market value and the price they paid.
This tax is often called a capital gains tax. If the stock is sold for less than its fair market value, the employee may also be subject to a "capital losses" tax. Another mistake businesses make is not understanding how to report restricted stock units (RSUs) on their tax return. RSUs are a type of equity compensation taxed when vested, not granted.
This means that businesses need to be aware of the vesting schedule and report the income on the employees' tax returns in the year they vest. So, many private companies must understand equity compensation's tax liabilities before offering it to employees. Failure to do so can result in penalties and interest charges.
How to ensure that you pay taxes correctly on your vested stock options?
Vested stock options give you the right to buy company stock at a set price, at the price the stock was trading when the option was granted. When your stock vests at the end of the prescribed vesting schedule, you own it and you can do with it as you may please, granted that you are aware of insider trading regulations, company policies, and blackout periods.
In such cases, you may decide to hold onto, sell, or exercise your option and buy the shares. Regardless of what you do with your vested stock, you'll need to pay taxes on it.
Here's how to ensure you're paying the correct taxes on your vested stock options.
When you vest, your employer will send you a Form 1099-B, which reports the income from the sale of your vested shares.
The form will show how many shares were sold and how much stock is priced. You'll use this information to calculate your capital gains or losses for tax purposes.
If you sell your shares for more than you paid, you'll gain a capital gain. You'll have a capital loss if you sell them for less than you paid. Either way, you'll need to report the sale on your tax return.
You still need to pay taxes if you don't sell your shares when they vest. You'll be taxed as if you sold the shares on the date they were granted, even if you don't sell them until later.
This is called a constructive sale. Hold onto your stock option shares for at least a year after they vest to avoid paying taxes on a productive sale. That way, you'll qualify for long-term capital gains rates generally lower than short-term rates. Paying taxes on your vested stock options doesn't have to be complicated.
83 B Election
An 83 b election, also known as a Section 83 b election, is a tax election that you, as an employee, can make to potentially reduce your tax liability when receiving equity compensation, such as RSUs or stock options, that are subject to vesting.
For instance, when you receive an RSU that is subject to vesting, the value of the equity typically becomes taxable as ordinary income at the time of vesting, based on the fair market value of the stock at that time. However, with an 83 b election, you can choose to include the value of the unvested equity in your taxable compensation income at the time of grant or purchase, rather than waiting until the equity vests.
By making an 83 b election, you can potentially reduce your overall tax liability, as the value of the unvested equity at the time of grant or purchase is typically lower than the value of the vested equity at the time of vesting. This can result in lower ordinary income taxes at the time of grant or purchase, compared to waiting until the equity vests and the value is higher.
It's important to note that an 83 b election is an irrevocable election, meaning it cannot be changed or revoked once made. Additionally, there are strict deadlines for making an 83(b) election. Generally, you must file the election with the IRS within 30 days of the grant or purchase of the equity. Failure to timely file the 83(b) election can result in adverse tax consequences.
Making an 83 b election requires careful consideration and evaluation of the specific tax implications and risks associated with equity compensation. It's highly recommended to consult with a qualified tax professional or financial advisor to fully understand the implications of an 83 b election and determine if it is appropriate for your individual circumstances.
By understanding how taxation works on startup equity and taking steps to cut your tax liability, you can ensure that you're paying the correct amount of taxes on your vested stock options.
Alternative Minimum Tax (AMT)
There may be situations where employees exercising stocks, particularly incentive stock options (ISOs), could inadvertently trigger alternative minimum tax (AMT) liability due to the specific tax treatment of ISOs. In such cases, companies and employees may need to account for the potential AMT implications and plan accordingly.
Here are some scenarios where AMT may come into play:
1. Early Exercise Options of ISOs
If an employee chooses to exercise early ISOs before the vesting period or holds onto the stock after exercise, the difference between the exercise price and the fair market value (FMV) of the stock on the exercise date may be considered a "preference item" for AMT purposes. This could potentially increase the employee's AMT liability, as the preference item is added back to their taxable income, resulting in a higher minimum tax calculation.
2. High Deductions or Exemptions
In certain cases, high deductions or exemptions claimed under the regular income taxes system may trigger AMT liability. For example, if an employee has a significant amount of deductions or exemptions, such as state and local taxes, miscellaneous itemized deductions, or exemptions for dependents, it could potentially trigger AMT liability, as these deductions or exemptions may be disallowed or limited under the AMT system.
3. Tax Preferences and Adjustments
AMT also applies to other tax preferences and adjustments, such as tax-exempt interest on certain private activity bonds, depreciation adjustments, and more. In some cases, these preferences and adjustments may increase the taxpayer's AMT liability.
What are some tips for minimizing your startup equity tax liabilities on restricted stock awards (RSU awards)?
According to the Internal Revenue Code (IRS), equity compensation, such as stock options and restricted stock units (RSUs), is considered taxable income. This means you will owe ordinary income tax on the equity when it is granted, vested, or sold.
But there are ways to cut the tax consequences on your stock option plan or RSU and maximize your business growth potential. Here are four tips:
Seek Tax Advice
Understand the equity tax obligations before granting employees or selling equity to investors. Get guidance from a tax professional to ensure you follow the law and cut your tax liability on what is considered taxable income from your employee equity.
Consider Tax Deferrment
Consider using an equity compensation plan that allows you to defer taxes on the equity until it is sold or vested. This can help you save on taxes in the short term and maximize the growth potential of your business in the long time.
Document the Fair Market Value
When you do grant equity, be sure to document the fair market value of the equity during the grant date. This will help reduce your taxes when the startup equity award is sold or vested.
Ensure Efficient Equity Compensation Management
Finally, keep good records of all equity grants and sales. This will help you track expenses related to your startup business and save money on your taxes in the long run.
These four tips can help you cut your startup equity tax consequences on compensation plans such as stock options and RSUs. If you’re the employer, these can help maximize business growth potential so that you can keep more of your hard-earned equity and use it to grow your business. Meanwhile, if you’re an employee, these will further optimize your gains, as equity plans are designed to give more.
Additionally, consulting with a tax professional regarding your unique compensation package is always recommended to ensure you take advantage of all opportunities to minimize your tax burden on your startup equity while still complying with the law. For anything else on equity packages, we at Upstock.io are here to answer your questions.
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