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When trying to attract and retain employees, tech start-ups might offer different types of equity awards to complement cash compensation. Whether you’re the employer or employee, make sure you understand the tax consequences of these awards.

Tax strategies

Tech Industry Tax Insights: Stock Compensation Basics

  • Michael De Prima
  • Patrick Smith
  • 11/13/2020

Key insights

  • Incentive stock options provide favorable tax treatment to employees, but are subject to strict holding period rules.
  • Nonqualified stock options provide more flexibility, but may have less favorable tax implications.
  • Restricted stock awards and restricted stock units offer an alternative to stock options that have become more widely used in recent years.
  • Employers should be cognizant of Section 409A when drafting equity compensation plans, while employees should be aware of the Section 83(b) election when receiving equity awards.

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Start-ups in the tech space often do not have sufficient cash to pay their employees a market salary — and let’s face it, tech employees can demand hefty paychecks. To attract these valuable resources, the industry has turned to various forms of equity awards to bridge the pay gap. These noncash compensation strategies can be an excellent win-win if structured correctly. Employers are able to attract and retain key employees while also giving their talent the opportunity to invest in the company’s growth and success.

There are several types of equity awards a start-up operating as a corporation could consider, and each has its own tax consequences.

Stock options

Popularized in Silicon Valley, stock options were arguably the earliest form of equity compensation and primarily include incentive stock options (ISOs) and nonqualified stock options (NSOs). The major difference between the two is their federal tax treatment.

Incentive stock options

ISOs, also known as statutory options, are subject to strict rules under the Internal Revenue Code and can only be granted to employees of the issuer. Once granted, and upon vesting of an ISO, there are no tax consequences to the employer or the employee.

There is generally no tax impact either when the employee exercises the options, though the bargain element of the stock (i.e., the spread between the fair market value and exercise price) can result in alternative minimum tax liability. However, in order to reap the favorable tax benefits of an ISO, the employee cannot sell the stock within two years from the grant date or within one year of the exercise date.

If the required holding period is met, the only tax consequence for the employee will be capital gains, which is based on the difference between the employee’s exercise price and the price at which the stock was sold. However, if the stock is sold prior to the expiration of the holding period, its sale is considered a disqualifying disposition and the bargain element will be taxed to the employee as compensation at ordinary income tax rates.

While ISOs provide preferential tax treatment to employees if the holding period is met, they can also negatively impact employers due to the lack of compensation deductions other forms of stock compensation provide.

Nonqualified stock options

Unlike ISOs, NSOs can be awarded to both employees and independent contractors. This can be an attractive feature for cash-sensitive start-ups that need to pay advisors and consultants.

The significant tax difference between the two types of stock options is that NSOs are taxed once they are exercised. Specifically, when NSOs are exercised, the bargain element of the shares is taxed as compensation income to the recipient and is deductible by the employer.

Restricted shares

Employers may also want to consider awarding restricted stock rather than options to employees. The two variants to consider, restricted stock awards (RSAs) and restricted stock units (RSUs), can both be freely issued to independent contractors.

Restricted stock awards

An RSA is a transfer of an employer’s stock that is subject to vesting requirements and includes the employer’s right to repurchase the shares during the vesting schedule. These characteristics prevent an employee from receiving shares and leaving the company immediately thereafter.

RSAs can be issued at no cost to the employee—at the stock’s current price or at a discount—which makes RSAs an attractive form of equity compensation when the employer’s stock value is minimal and is expected to increase.

RSAs are taxed to the employee when vesting occurs based on the difference between the value of the stock at the time it vests and the price the employee paid for such stock. Similar to options, this spread is taxed as compensation income at ordinary rates and the employee will be subject to capital gains when the shares are ultimately sold. The employer is generally entitled to a deduction for the year in which the employee is taxed on the spread.

Restricted stock units

An RSU gives the recipient the right to receive a transfer of the employer’s stock at a future date or a transfer of a cash equivalent, subject to vesting requirements. If the units are settled in stock, the employee recognizes ordinary income based on the fair market value of the shares on the date of transfer. There would then be capital gain or loss treatment upon selling the stock. If the units are settled in cash, the employee must recognize ordinary income in the taxable year the cash payment is actually or constructively received. Similarly, the employer is entitled to a compensation deduction in the same year.

Beware of Section 409A issues

Section 409A governs the federal tax treatment of various forms of deferred compensation. It’s important to remember that equity awards (other than ISOs) can fall under Section 409A’s purview, and violations can result in both taxes and penalties to grantees of an award. As such, it’s vital to have any equity compensation plan drafted and reviewed to comply with Section 409A.

The Section 83(b) election

Elections under Section 83(b) are well-known in the world of equity compensation. Many associate the election with any equity award without fully understanding whether it can be made for a particular grant, or more importantly, whether such an election is even to an employee’s advantage.

Employees typically must have the underlying stock in hand (even if it is subject to restrictions and forfeiture) since options themselves are typically not eligible for the Section 83(b) election. For this reason, the election is most closely associated with RSAs.

The employee must recognize ordinary income when the election is made, based on the fair market value of the award. This is often advantageous for recipients of  awards where the value of the underlying stock is expected to appreciate prior to its stated vesting date. However, the decision to make a Section 83(b) election is an important one that must be thoroughly analyzed. The election itself must be made within 30 days of the transfer and, once made, can be revoked only in very limited circumstances.

The Tax Cuts and Jobs Act of 2017 further introduced Section 83(i), which permits certain employees of privately held corporations to defer the taxes on NSOs and the settlement of RSUs up to five years if several requirements are met. This election is separate from the Section 83(b) election, but must also be made within 30 days of exercise or settlement.

Tax reporting requirements

When an employee’s equity award is taxed as compensation income, the taxable amount must be reported on Form W-2 (or Form 1099-MISC in the case of an independent contractor), and the employer is generally required to withhold federal income and FICA taxes on taxable amounts, which can apply at the time of vesting or exercise, depending upon the type of award at issue and whether a Section 83(b) election is made. Due to these payroll and withholding obligations, employers must track and coordinate taxable awards with their payroll processors. In the case of an ISO exercise, employers must also issue a Form 3921 reflecting certain information about the exercise.

How we can help

Tech start-ups continue to rely heavily upon various forms of equity compensation to attract, retain, and reward talent. When structured properly, these plans benefit employers and employees. However, there are a number of tax issues and potential pitfalls that can be encountered when setting up and administering a plan.

A thorough understanding of the tax consequences associated with each form of equity compensation is critical. Whether you are a tech start-up trying to craft and implement a compensation plan or an employee trying to understand your equity-based compensation, CLA is here to help.

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