Our federal tax system, the public policy, makes it unnecessarily difficult for private companies to share stock with their employees, contractors, advisors, and other service providers.
The problem lies in our tax law.
The Problem with Issuing Shares to Workers
Why doesn’t your employer bonus your shares? Because the IRS treats any share bonus as if the company paid you cash equal to the value of the shares, and then you used that cash to turn around and buy the shares.
This means that if you are an employee and your employer bonuses your shares, you actually have to write the company a check (!) — so that the company can send the IRS the income and employment taxes it was required by law to withhold from you.
Frequently, employees can’t bear the tax burden associated with a share award. For example, suppose your employer wanted to award you 100,000 shares, and the shares were valued at $1.00 per share based on the company’s most recent 409A valuation. That would be $100,000 in taxable income. The tax withholding that the employer must make from the employee on a $100,000 cash bonus is significant.
The current supplemental wage withholding rate is 22%. Therefore, the employer must ask the employee to write the company a check for $22,000.
Plus, the company must also withhold the employee-side FICA tax — an additional 7.65% of all compensation until you hit the FICA wage base, and then only hospital insurance tax of 1.45% needs to be withheld.
To add to this tax problem, also remember that you cannot turn around and sell any of the shares you receive because there is no market for the shares and the securities laws place restrictions on your sale of the shares, and your company’s documents probably contain restrictions on transfer (such as a right of first refusal) as well.
All in all, this makes it difficult for employers and employees alike to share in a company’s equity by issuing stock awards.
What if the shares are subject to vesting?
Issuing the shares subject to vesting doesn’t solve any problems. In fact, it makes the tax matters worse. You can file an 83(b) election and be taxed on all the shares upon receipt, despite them being subject to vesting. Or you can not make such an election and be taxed when the shares vest at their value at that time. This means if the stock goes up in value, you owe even more—sometimes way, way more—in taxes.
The Alternatives: Stock Options Priced at No Less than Fair Market Value
To solve this problem, private, non-public companies typically turn to stock options priced at not less than fair market value (FMV) at the time of grant.
Stock options are frequently used by private companies as a substitute for share awards because as long as the stock option is priced at not less than FMV at the time of grant, there are no immediate tax consequences to the optionee or the company. Instead, the tax event is deferred until the options are either exercised or cashed out.
However, this deferral comes with downstream difficulties.
Many companies take 7-10 or more years to have a liquidity event—IPO or acquisition—and employees typically wait to get cashed out on their options in connection with such a liquidity event. So employees typically have to stay with the same company through that entire time to reap the benefits of their options. Often times, an employee is taking the job at a startup for a lower than market salary in exchange for the upside of options, which is always a gamble.
And what about the many employees who don’t stay 7-10 years? Many companies provide former employees only 90 days after leaving to exercise their options. However, this is a problem for a lot of optionees for reasons similar to companies bonusing employees shares—because it can be cost-prohibitive to (i) pay the exercise price, and (ii) pay the company all the income and employment taxes so the company can remit it to the IRS. So if an optionee leaves the company, they need to dig (sometimes deep) into their own pocket to keep their equity; otherwise, they lose it forever.
ISOs Don’t Solve the Problem
Wait, you say—don’t incentive stock options solve this problem? No. If there is a spread on the exercise of an ISO, the alternative minimum tax consequences can be severe and untoward.
What About Restricted Stock Units (RSUs)?
RSUs don’t solve any problems with private companies because when your RSU vests and is “settled,” you receive fully vested shares of stock. This is not good because, at this point in time, you now owe tax on the value of the shares received as if your employer gave you the cash and you used the cash to buy the stock. See the discussion of tax withholding above.
RSUs work great for companies like Microsoft and Amazon because those companies have robust public markets for their shares, and employees can turn around and immediately sell half the shares received so that the taxes can be paid. But this doesn’t work in the private company context for the reasons described above.
So, What’s the Solution?
We Need Congress To Fix The Problem
Congress should pass a law that says that transfers of stock to workers are not taxable if the company is not public. Instead, the tax will be levied when the shares are sold. This would allow companies to share equity with workers without having to go through convolutions and contortions from a legal and tax perspective to do so. The government won’t lose much money because right now, these transfers largely don’t take place anyway because of the tax.
This is a chance for Congress to do something which would have a positive impact on many lives and businesses.
Disclaimer: this post is for informational/educational purposes only. It is not intended to provide any legal advice.
By: Joe Wallin
For more articles like this, please visit our main page, here.