Tax Considerations for Equity Compensation

Tax treatment of equity awards is a matter of particular concern for both an employee and employer. Tax laws are extensive and detailed. Even minor unintentional violations bring significant penalties and/or forfeiture of the intended benefits. Corporate attorneys and accountants should structure the company’s equity compensation programs in a tax-efficient manner. Employers must precisely understand the tax consequences of their equity compensation arrangements and communicate it to the employees or other parties whom equity compensation may be granted. Employees may be penalized for the mistakes made by the employers and other way around. The laws hold both parties responsible to ensure proper compliance.

Here is a brief description of the Tax Treatment of Different Types of Equity Awards

Restricted Stock – not taxed at grant unless a receiver makes a Section 83(b) election to be taxed at grant (usually recommended); not taxed at vesting if Section 83(b) election is made, otherwise, taxed as ordinary income on each date a portion of equity vests (taxes are based on the difference between the fair market value of the stock on the vesting date and the amount initially paid for the stock); taxed as a capital gain or loss at the time of sale (if no Section 83(b) election is made, the holding period begins at vesting. If election is made, the holding period begins at grant). An employer entitled to a tax deduction corresponding to the amount of ordinary income recognized by the employee.

Non-qualified Stock Options – not taxed at grant; not taxed at vesting; taxed as ordinary income at exercise (based on the difference between a fair market value and the exercise price); taxed as a capital gain or loss at the time of sale. An employer has to withhold and pay all employment taxes and is entitled to a tax deduction corresponding to the amount of ordinary income recognized by the employee on exercise.

Incentive Stock Options - not taxed at grant; not taxed at vesting; not taxed at exercise (but the difference between a fair market value and the exercise price is a tax adjustment item for purposes of calculating alternative minimum tax, which can be significant); taxed as a capital gain or loss at the time of sale (if the sale occurs within one year from the date of exercise or two years from the grant date it is considered a disqualifying disposition and the employee taxed at the ordinary income rate). The employer is entitled to a tax deduction corresponding to the amount of ordinary income recognized by the employee only if a disqualifying disposition occurs.

Restricted Stock Units (RSUs) - not taxed at grant; not taxed at vesting if the award is exempt or complies with Section 409A of IRS; taxed as ordinary income equal to the fair market value of the stock or the cash provided on settlement; taxed as a capital gain or loss at the time of sale (based on the difference between the sale price and the ordinary income recognized at settlement). An employer is entitled to a deduction corresponding to the amount of ordinary income recognized by the employee.

Stock Appreciation Rights (SARs) – not taxed at grant; not taxed at vesting; taxed as ordinary income at exercise (based on the amount of cash or a fair market value of the stock received); taxed as a capital gain or loss at the time of sale (based on the difference between the sale price and the ordinary income recognized at exercise). An employer is entitled to a deduction corresponding to the amount of ordinary income recognized by the employee.

 

Two main Sections of IRS Code that are applicable to the equity compensation in startup companies are Section 83(b) and 409A. Section 83(b) governs the taxation of equity transferred to an employee or other service provider in connection with the performance of services. Section 409A regulates taxation of deferred compensation.

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