Startup companies are very often cash poor, but future rich meaning they typically do not have a lot of money in the bank, but the business itself may have a very bright future. Especially in the high-tech startup world the trip from birth to substantial market value for a business can happen pretty quickly. This has made equity compensation an attractive option for many startup ventures. This article will help you understand the three major forms that equity compensation may take and the tax implications of each.
Incentive Stock Option-ISO’s
Incentive Stock Options(ISO’s) receive very favorable tax treatment. There is no income tax when the company grants the ISO, nor is there tax when the employee exercises an ISO. There is income tax when the employee sells the stock, but the gain is taxed as a capital gain which generally is taxed at lower rates than ordinary income.
One area you want to avoid with ISO’s is a Disqualifying Disposition. Disqualifying Disposition happens when the employee sells the stock purchased through an ISO either within one year from the date the ISO is exercised (the date you actually purchase the stock) or within two years of when the ISO is originally granted. A disqualifying disposition changes the gain from a long-term capital gain to ordinary income which is taxed at higher rates.
Other considerations with ISO’s are the possible impact on Alternative Minimum Tax and there is a limit of $100,000 per employee per year in the value of ISO’s that can be exercised. Stock options in excess of the $100,000 would be considered Nonqualified Options which are discussed below.
There are also limitations the employer must consider when establishing an ISO plan.
1. The exercise price cannot be less than the fair market value on the date the option is granted.
2. The option term cannot exceed 10 years.
3. The option can only be exercised by the employee and cannot be transferred except upon the death of the employee.
4. The employee cannot already own stock equal to more than 10 percent of the voting power of the employer or its parent or subsidiaries. (There are some limited exceptions to this rule)
5. The ISO plan must be approved by the employer’s stockholders within 12 months of adoption.
6. The employer does not receive a tax deduction for granting the options, unless there is a subsequent disqualifying distribution.
Nonqualified Stock Options-NSO’s
If a stock option does not meet the ISO requirements then it is considered a nonqualified stock option (NSO). Like ISO’s there is no income recognized when an NSO is granted; however, the employee does recognize income upon exercising the NSO. When an NSO is exercised the employee has ordinary income equal to the fair market value on the date options are exercised less the option price or amount paid for the stock. For example if an employee exercises stock options for 10,000 shares at an option price of $10 and on the date of exercise the fair market value (FMV) of the stock is $15, then the employee has $50,000 ($15 FMV – $10 option price) or $5 times 10,000 shares.
If stock purchased through an NSO is subsequently sold, the employee would recognize capital gain equal to the selling price minus the FMV of the stock on the date the stock was purchased (that should be the same number as the option price paid plus any ordinary income recognized when the options were exercised)
Restricted Stock Units-RSU’s
Restricted stock means that the stock has actually been transferred to the employee (not just an option to purchase stock at a later date), but there are restrictions on the employee’s ability to sell the stock. With RSU’s the employee does not recognize income until the stock fully vests, meaning when the restrictions that prevent the employee from selling the stock are removed or expire. When RSU’s fully vest the employee would have ordinary income equal to the difference in the FMV on the date of vesting and any amount the employee was required to pay for the stock. Later if the employee sells the stock, they recognize capital gains income equal to the selling price price minus the FMV of the stock vested (that should be the same number as the purchase price paid plus any ordinary income recognized when the stock was fully vested)
When an employee receives RSU’s, they have the option to elect to accelerate recognition of the ordinary income. This is known as an 83(b) election. While an 83(b) election can result in significant tax savings to the employee, there are very specific rules to be followed and the employee should also consider the possible downsides to an 83(b) election if the value of the stock does not increase.
To learn more about making 83(b) elections, connect with me at: Wray Rives on TaxConnections