Employees may soon be able to defer taxes on stock options. But is the new law all it’s cracked up to be?
Clearly, there’s not a lot of cooperation happening in our government these days. But in September, the House of Representatives passed the Empowering Employees through Stock Ownership Act (EESO). Is this a rare piece of effective bi-partisan legislation that truly helps innovative companies attract talent and allows startup employees a way to cash in on the value they provide their employers? It looks like a good start, but with limitations. Whether you are running these companies or investing in them, it’s important to understand what those limitations are.
A vexing problem
The challenge that EESO aims to address has been with us for a while. Many employees at private companies simply can’t afford to exercise their options under current tax law since they trigger a tax hit, either in the form of taxes due at exercise or an AMT (Alternative Minimum Tax) hit. The intent of this new legislation is to enable employees at startups a way to exercise their options and defer any taxes for up to seven years (or until the employee has a way to cash in the stock for value).
This matters more than ever because many startups are choosing to remain private longer these days. Employees in rapidly growing startups often find it difficult to leave a company because exercising their stock options would create a tax bill well beyond their means. But at the same time, not exercising could mean leaving hundreds of thousands of dollars behind.
The EESO bill, which could take effect at year-end if passed by the Senate, aims to rectify this conundrum. It sounds like a good start, but let’s consider some of the fine print.
- One of the requirements is that 80% of the company's employees need to be granted options. In a year where 80% of employees did not receive grants, none of the employee grants made would qualify.
- There is a reference that all employees must have “the same rights and privileges,” which could be tricky in a start-up environment. Occasionally companies give unique rights to an employee that they are trying to recruit. This could nullify the ability for any of the grants to be “Qualified Grants”.
- The proposed law requires companies to provide information about the tax impact to any employee electing to defer, particularly in the event that the company’s value declines over time. Should the employee take the election to defer taxes, the company will also be responsible to report the future tax liability on a W-2 for the employee.
- And don’t forget, companies don’t necessarily like the idea of making it easier for key employees to switch jobs after a year or so by allowing them to take equity with them. Stock options are a key benefit that’s helpful in attracting talent, but options can also act as “handcuffs” and be helpful in retention as well.
Understand the ramifications
Importantly, employees need to fully understand the risks associated with taking an election to defer taxes. For example, if the company has not gone public or been acquired within seven years of exercising the options, employees could be faced with a large tax bill and no means to pay it. Secondly, the EESO bill will likely only apply to federal income taxes, which means employees are still on the hook for State, Social Security and Medicare taxes. Taking the election to defer taxes would turn an Incentive Stock Option (ISO) into a Non-Qualified Stock Option (NQSO). This may not be in the employee’s best interest depending on his or her individual tax status. Finally, it’s not entirely clear how employees will make this election, other than they will have to indicate within 30 days of purchasing the shares (or in the case of RSUs, 30 days of issuance).
And then there is the issue of excluded employees. Certain employees may be prohibited from taking this election, including if they have been:
- A 1% owner, CEO or CFO, or family member of one of these
- One of the four highest compensated officers of the corporation at any time during the previous 10 years
If an employee takes the election to defer taxes and then becomes an excluded employee, they will be subject to the taxation on those options in the year they become an excluded employee.
Hypothetically speaking*…
Everyone loves options. Stock options, that is, can be loved but are also tricky. These potentially lucrative benefits can have eye-popping near-term tax implications for startup employees. Consider a hypothetical scenario where Sally, a brilliant software engineer, decides to execute her stock options (ISO’s) received as part of her compensation package.
- We assume:
- The cost of her options is $10,000 and the spread between her cost and the FMV (as defined by 409(a)) is $200,000:
- The tax bill:
- Under the current scenario, Sally would have to pay $10,000 to exercise the stock options, but her tax implication could be as much as $70,000 (via Alternative Minimum Tax--$56,000 for federal AMT and $14,000) for the tax year in which she exercises the options. However, if Sally were able to make the election to defer, the option would become an NQSO and she would only have to pay applicable Social Security taxes (a maximum of $7,347 for 2016) and Medicare taxes $2,900 (plus any additional over the threshold). While that’s not insignificant, the proposed law would allow her to defer the federal withholding of more than $50,000. This sounds great; however, there are still the state tax implications.
- However, Sally lives in high-tax San Francisco, and she still needs to consider her obligations to the State of California. Under this scenario, she would likely face state tax withholding of more than $20,000. This means instead of paying $10,000 for the options and managing a possible AMT bill of $70,000, she could have to put up over $40,000 to exercise her shares and still owe $50,000 in federal taxes in the future (plus capital gains on any increase in value).
So while this proposed law might be effective in helping Sally, the decision to exercise her options still has ramifications and should be done only after considering her entire tax situation holistically and consulting a tax advisor.
*The above is a hypothetical example for discussion purposes only with approximations of tax ramifications. Neither SVB Wealth Advisory, nor SVB Private Bank provides tax or legal guidance. Please consult your tax advisor for your specific situation.
Conclusion
Ultimately, the EESO legislation may not be a panacea, but it may give more freedom to employees that currently feel trapped by their circumstances. While this could be viewed as an “extra benefit” that is beneficial for startups competing for talent and recruiting new employees, the new reporting and monitoring implications alone might keep younger start-up companies from considering the implementation of such grants.
If you'd like to understand how the proposed legislation could make sense for you, or your business, we'd be happy to meet with you.
