Taxes on Equity Compensation, What You Need to Know: Part 1

As a startup founder, equity compensation is highly likely to be an essential part of your recruitment plan and retention strategy. Getting it right goes beyond crafting an attractive benefits package. You also need to understand the differences between different types of equity, including the consequences of  of taxes on equity compensation and accounting for equity grant tax implications.

Types of equity compensation

Equity compensation isn’t just about stock options. While they are still the most common form of equity grants, they aren’t your only option, so to speak. Other types of equity compensation include restricted stock, restricted stock units (RSUs), stock appreciation rights (SAR), and phantom stock. Stock options and RSUs are ones we see startup companies using most often.

Taxes on Equity Compensation

Getting, giving, or exercising ISOs (incentive stock options) doesn’t trigger any taxes. But, when you sell the shares you’ll owe capital gains tax on the difference between your exercise price and the fair market value, or selling price of the stock.

But there’s a big catch, called the minimum holding period. In order to get taxed at the lower capital gains rate instead of the income tax rate, you must hold your exercised stock for two years from the date of your grant and one year from the sale. If you don’t follow those conditions, your sale will be classified as a “ disqualifying disposition.” If that happens, you’ll have to pay tax at your regular income tax rate.

Because you can choose when you pay taxes, based on when you decide to cash out, ISOs allow for flexibility with your tax strategy. Just keep in mind that in some cases, exercising your option on the shares can trigger the alternative minimum tax (AMT) on your unrealized gains. That can make calculating how much tax you owe much more complex. It also means you’ll end up paying more tax than you expected to.

Whether or not you hold on to your ISOs long enough to be taxed at the lower capital gains tax rates, 15% or 20% for your federal taxes, you’ll also most likely have to pay state taxes too. And some states, like California, don’t have a lower tax rate on capital gains. So you would pay taxes at the regular state income tax rates.

How is Equity Taxed for

NSOs (non-qualified stock options) are more flexible, since they can be granted to anyone, not just employees. But they don’t have the same tax advantages for the grantee that ISOs do. If you own NSOs when you exercise them, you’ll pay taxes at ordinary income tax rates.

If you grant NSOs to your employees, you’ll have to determine and withhold taxable income and payroll taxes, including FICA and Medicare, when they exercise their options. 

So why use NSOs? For one thing, NSOs don’t generally come with all the restrictions on holding periods that ISOs do. And they do have a tax benefit. If you grant NSOs to your employees, you can take a tax deduction on the difference between the grant price and the exercise price when employees sold their shares. 

When might you want to choose one versus another?

In those early days while you’re building your business, equity compensation can be a great way to align incentives, enable your key hires to share in the potential upside, and concentrate your team’s focus on the long-term. But a lot of considerations go into when, whether, how, and who you grant equity to. 

In practice, you typically want to reserve ISOs for key employees. NSOs might make sense for other types of employees, strategic advisors and/or consultants, and your startup board members. You’ll want to get legal and tax advice before giving out equity, to make sure you structure your program in a way that makes strategic and financial sense complies with IRS and SEC law. 

Equity compensation, Tax Treatment, and 409A valuations

Before you offer shares or options, the IRS requires you to do or have a 409A valuation completed to set the exercise price for your company’s stock. These can be expensive, but if you’re tempted to try to save money by skipping this step, it’s not worth it. You and any employees you give startup equity to will have to pay extra taxes on their stock option compensation and could also be hit with hefty fines.

You may be best off finding a ​​startup tax advisor to help set this up.

We've got more to say on this subject... read Part 2 here.