Tax Planning for Startup Employees
Working for a startup can be an exciting prospect that gives you an opportunity to make a significant impact on a company’s culture as well as the products and services they bring to market. Compensation can get tricky, however, as cash-strapped new companies look for creative ways to compensate employees. Stock options and incentives can pay out extremely well but can also complicate your income tax picture. Different employer equity compensation plans create different tax repercussions. This article will help with tax planning for founding startup employees.
Employer Equity Compensation Explained
Incentive Stock Options (ISOs)
It’s common for companies to offer startup employees ISOs. When they do, the company sets a price called the strike price. This is the price at which employees can buy shares of stock — even if those shares are worth more in the market.
This can be a great way to buy stocks at a discount, but it does create a tax concern. Let’s say, for instance, that you buy a share of stock from your company at the strike price of $10. The day you purchase the stock, its fair market value is actually $25 a share. In this case, buying the stock instantly creates taxable income of $15: the $25 value of the share minus the strike price you paid. This income comes into play when calculating your alternative minimum tax (AMT).
As is true of all stocks, you may find yourself taxed again if and when you sell. This is where things get tricky. Some of the income from the sale gets counted as capital gains, as usual. But the IRS may tax some of your income as compensation instead. If you’ve held the stock for less than 2 years, you’ll likely have only long term capital gains tax to report, but there are exceptions.
Companies can only issue ISOs to employees and independent contractors. They’re also limited to $100,000 per year.
Nonqualified Stock Options (NSOs)
NSOs work in a similar fashion to ISO’s. ISO’s, however, can only go to employees and independent contractors. A company can grant NSOs to anyone, including outside consultants and vendors. There is no annual limit on the dollar value of NSOs.
Like ISOs, NSOs are sold at a predetermined strike price. Once again, a strike price beneath the stock’s fair market value creates an instant tax liability. This money gets taxed as ordinary income but has no effect on income when calculating your AMT.
You will have to pay capital gains on your NSO stock if and when you sell it, but that’s it. All of the income from the sale is taxed that way, so you won’t have to figure out how much of the sale is compensation like you do with an ISO.
Restricted Stock (RS) and Restricted Stock Units (RSUs)
Restricted stock (RS) and restricted stock units (RSUs) are also popular compensation methods for startup employees. RS is given to company executives, but ownership of the stock comes with certain caveats. In order to keep it, the executive must stay at the company long enough to become vested in the stocks. She may also have to give the stock back if certain performance goals aren’t met.
RSUs work a little differently than RS. They’re a promise that if an employee stays with the company long enough to become fully vested in a stock, they will receive shares. Unlike their restricted counterparts, RSUs are not owned by the employee until he becomes vested.
When the stock is granted, the employee must pay income tax on its fair market value. This is considered an ordinary tax, however, and is therefore taxed at the same tax rate as his normal compensation. As always, capital gains tax comes into play when and if the employee sells the stock later.
There is a tax law that can give you some wiggle room on fair market value if your compensation includes RS rather than RSUs. Known as the section 83(b) election, you may have the option of choosing whether your stock is valued when you’re granted it or when you become vested in it. This can make a big difference.
Employee Stock Purchase Plans (ESPPs)
ESPPs are unique in that they allow employees to purchase stock in the company through payroll deductions. Employees can typically purchase the stock at a lower price, purchasing it for no less than 85 percent of its fair market value. There are no tax consequences when buying or taking full ownership of the stock.
The stocks acquired through an ESPP are taxed like other securities when sold. Like stocks acquired through ISOs, selling shares acquired through an ESPP may result in both ordinary income and capital gains at the time of the sale.
Qualified Small Business Stock (QSBS)
The QSBS stock exemption, often referred to as Section 1202, is an extremely powerful tool that saves taxpayers massive amounts of money. Under Section 1202, employees holding shares in a small business can exclude up to $10 million in capital gains tax when selling stock. That’s not a typo.
In order to do so, you must meet all of the following criteria:
- The stock issue date must be after August 10,1993
- The sock musts be from a domestic C-corporation
- The business must be valued at less than $50 million
- You’ve owned the stock more than 5 years
- You are not a corporate taxpayer
- The business that issued the stock must be currently open and running
Given the massive savings potential of the QSBS exemption, your odds of an audit do increase if you take it. This isn’t an insignificant tax deduction but a major exemption that is sometimes literally worth millions. The IRS likes to make sure this little-known exemption isn’t abused, so keep good records if you take it.
Biden’s New Tax Plan & Capital Gains Tax
President Biden is considering making some changes to the taxation of capital gains. As of this moment, the plan is simply that — it may or may not become law. If the plan does become law as currently written, the IRS will tax capital gains over $1 million at a much higher rate.
This could have a large impact on startup employees who accept stock as part of their compensation plan. Several details of the plan are not yet clear, however, and many things could change on the path from idea to law. Still, you may want to keep an eye on this possible change so you can plan a new tax strategy if necessary.
To make a long story short, startup stock compensation plans are complicated. They create lots of tax consequences, some of which can result in pretty high tax bills. There are lots of legal ways to minimize your tax, but it’s important that you truly understand all the rules so you don’t use them incorrectly.
If you’re getting stocks as part of your compensation plan, sign up for Picnic Tax today for help understanding these complicated matters and to formulate a sound plan to reduce your tax liability. This particular area of tax law goes much deeper than most taxpayers wish to venture alone and can even stump basic tax software. It doesn’t confuse our professional CPAs, though, and we’re standing by ready to help you.