Taxes on equity: What you need to know?

Equity is a powerful tool in the startup ecosystem, acting as both a means of compensation and an investment vehicle. For founders, employees, and investors, equity represents ownership in a company, translating into significant financial rewards as the business grows. However, with these potential gains come tax obligations that can impact financial outcomes significantly. 

For founders, equity is often used to attract talent and investors, but it requires careful tax planning to maximize benefits. Investors need to understand the taxation of dividends and capital gains from their equity investments. Employees receiving equity as part of their compensation must be aware of the tax implications of employee stock options and grants to manage their financial expectations effectively.

This blog explores the tax implications for various types of equity compensation and investment, along with strategies to manage these taxes efficiently. Keep reading to learn more.

Understanding Equity Compensation and Investment

Equity compensation is a type of non-cash payment that represents ownership in a company. Here are the common types:

• Stock Options: Herein, employees are granted the option to purchase company stock at strike price. They come in two main types:
  • Incentive Stock Options (ISOs): Often offered to employees, ISOs have favorable tax treatment but come with certain restrictions.
  • Non-Qualified Stock Options (NSOs): Available to employees, directors, and external consultants, NSOs are taxed as ordinary income upon exercise.

• Restricted Stock Units (RSUs): RSUs are company shares given to employees, subject to vesting conditions. Once vested, they convert into shares or their cash equivalent. RSUs provide clear ownership stakes and align employees' interests with company performance.
• Restricted Stock Awards (RSAs): Similar to RSUs, Restricted Stock Awards (RSAs) are shares granted to employees, typically at an early stage in the company's life. 

Equity compensation offers a potential financial upside for both employees and investors. Employees benefit from alignment with company success and retention incentives, while investors gain ownership and potential returns. However, both parties must carefully consider tax implications.

How Are Stock Options Taxed?

Understanding how stock options are taxed is crucial for managing your financial outcomes. Here’s how ISOs and NSOs are taxed:

• Incentive Stock Options (ISOs): Often granted to employees, ISOs offer favorable tax treatment. When employees exercise ISOs, the difference between the exercise price and the Fair Market Value (FMV) of the stock is not subject to regular income tax. 

Instead, this amount, known as the bargain element, is subject to capital gains tax at the time of stock sale. However, ISOs may trigger the Alternative Minimum Tax (AMT), a parallel tax system designed to ensure that high-income individuals pay a minimum amount of tax. The bargain element is added to their income for AMT purposes in the year of exercise.

Example: Suppose your employee has ISOs to buy 1,000 shares with an exercise price of $10 per share, and the FMV at exercise is $30 per share. The bargain element is $20,000 ([$30-$10] * 1,000). This $20,000 is subject to AMT in the year of exercise, but capital gains tax applies when the shares are sold.

• Non-Qualified Stock Options (NSOs): Unlike ISOs, NSOs are taxed as ordinary income at the time of exercise. The difference between the exercise price and the FMV of the stock is considered taxable income. When the employee eventually sells the stock, any additional gain is taxed as capital gains.

Example: If your employee has NSOs to buy 1,000 shares with an exercise price of $10 per share, and the FMV at exercise is $30 per share, the bargain element is $20,000. This amount is taxed as ordinary income in the year of exercise. If they later sell the shares at $50 per share, the additional gain of $20,000 ([$50-$30] * 1,000) is subject to capital gains tax.

When is Equity Taxed?

Taxes on equity are triggered by key events such as the vesting of restricted stock, the exercise of stock options, or the sale of shares. Understanding these events can be helpful in managing your tax liabilities effectively.

• Vesting of Restricted Stock: When restricted stock vests, it is considered taxable income. The FMV of the stock at the time of vesting is taxed as ordinary income. This means that employees must pay taxes on the value of the shares they receive, even if they do not sell them immediately.
• Exercising Stock Options: Exercising stock options can result in taxable income. When it comes to NSOs, the gap between the exercise price and the FMV is regarded as ordinary income. For ISOs, this difference can trigger the AMT, although it is not subject to regular income tax until the shares are sold.
• Selling Shares: Selling shares may incur capital gains taxes depending on the holding period. If you hold the shares for more than one year before selling, the gain is considered long-term and is subject to a lower capital gains tax rate. If you sell the shares within one year, the gain is short-term and taxed at the higher ordinary income tax rate.

Taxes on Restricted Stock Units (RSUs)

RSUs are not taxable at the time of grant. The taxation event occurs when the RSUs vest, meaning when the shares officially become yours (or your employees') and are no longer subject to forfeiture. At that point, the FMV of the vested shares is treated as ordinary income for tax purposes. The amount is added to the total taxable income in the year of vesting, and it will be taxed at the applicable ordinary income tax rate​.

For your employees, you need to withhold taxes on the FMV of the RSUs at the time of vesting. However, the amount withheld may not fully cover the employee's total tax liability, depending on their overall income for the year. This means your team members could face additional taxes owed at year-end. This immediate tax on equity compensation can be challenging, especially if the shares cannot be sold right away to cover the tax obligation.

Unlike ISOs, RSUs do not offer any preferential tax treatment. The entire value of the RSUs at vesting is subject to ordinary income tax rates, which can be higher than capital gains tax rates. To manage the tax liability associated with RSUs, employees can consider the following strategies:

• Sell Shares Upon Vesting: Employees can sell some of the vested shares immediately to cover their tax liability. This approach ensures they have the funds to pay the taxes without needing to dip into personal savings.
• Plan for Tax Payments: Employees should anticipate the tax liability and set aside funds in advance. This proactive approach can prevent financial stress when the tax bill is due.
• Seek Professional Advice: Consulting a tax professional can help employees understand their specific tax situation and explore strategies to minimize their tax burden.

Tax Implications of Capital Gains on Equity

Capital gains result from the sale of an asset, such as stocks, for more than its purchase price. The tax treatment of these gains depends on the holding period of the asset.

• Short-Term Capital Gains: If the equity is held for less than one year before being sold, the gain is considered a short-term capital gain. Short-term capital gains are taxed as standard income, which means they are subject to a less favorable tax treatment. This can result in application of higher ordinary income rates compared to long-term capital gains. 
• Long-Term Capital Gains: If the equity is held for more than one year before being sold, the gain is considered a long-term capital gain. Long-term capital gains benefit from a lower tax rate, which is typically more favorable than the ordinary income tax rate. This can result in significant tax savings and is a key strategy for maximizing investment returns. 

Here’s a taxable capital gain example to understand it better. Suppose an employee sells shares of stock they held for six months. The purchase price was $20 per share, and the selling price is $40 per share. The $20 gain per share is taxed as ordinary income. If the same employee holds the shares for 18 months before selling, the $20 gain per share is taxed at the lower long-term capital gains rate.

Taxation on Private Equity

Private equity differs significantly from publicly traded stock in terms of taxes on equity, presenting unique challenges and opportunities for your employees and investors.

• Qualified Small Business Stock (QSBS) Benefits: One key advantage is the QSBS exemption. If your company meets the criteria, employees and investors may be eligible for considerable equity taxation benefits. As per section 1202 of the Internal Revenue Code (IRC), up to 100% gains from the sale of QSBS held for more than five years may be excluded from federal income tax. This can be a powerful incentive for long-term investment in your company.
• 409A Valuations: For private companies, the FMV of stock options must be determined through a 409A valuation. This valuation impacts the pricing of stock options and their associated tax implications. A 409A valuation ensures that stock options are not granted at an unfairly low price, which could lead to severe tax penalties for your employees. It is essential to conduct regular 409A valuations to stay compliant and provide accurate tax reporting.

Unlike publicly traded stock, private equity is not easily liquidated, which can complicate tax planning. Employees holding private company shares must be aware that they could face substantial taxes on equity when they eventually sell their shares. In some cases, employees may defer taxes on private equity until a liquidity event, such as an acquisition or IPO. This can provide tax planning flexibility, but it also requires careful consideration and timing.

Alternative Minimum Tax (AMT) and Equity

When employees exercise ISOs, they should be aware that this can increase their AMT liability. If they do not sell the shares in the same year, they may face a significant tax bill without the liquidity to cover it. To avoid unexpected taxes on equity, employees need to plan carefully and consider the timing of exercising their options.

• Exercise in Small Batches: Employees can exercise their options in smaller batches over several years to spread out the tax liability and avoid triggering AMT in a single year.
• Sell Shares in the Same Year: By selling the shares in the same tax year as the exercise, employees can generate liquidity to cover the AMT liability. However, this may convert the potential capital gain into ordinary income.
• Consult a Tax Professional: Encourage employees to work with a tax advisor to understand their specific situation and explore strategies to minimize AMT impact.

Strategies to Manage Equity Taxes

Effectively managing taxes on equity requires strategic planning and an understanding of the available tax relief options. Here are some key strategies you can employ:

• 83(b) Election: For restricted stock, the 83(b) election allows employees to elect to be taxed at the time of the stock grant rather than at vesting. This means they pay taxes on the value of the stock at the grant date, which can be advantageous if the stock's value is low. Any future appreciation is then taxed as a capital gain upon sale, potentially at a lower tax rate.
• Qualifying Dispositions on ISOs: To benefit from favorable tax treatment on ISOs, employees should aim for qualifying dispositions. This means holding the shares for at least one year after exercising the options and two years after the grant date. Qualifying dispositions ensure that the gain is taxable at a lower long-term capital gains rate instead of ordinary income.
• Deferred Compensation Plan: Establishing a deferred compensation plan allows employees to delay getting a part of their income till a later date, typically retirement. This deferral can reduce current tax liabilities, as taxes are paid when the compensation is received, usually at a lower tax rate.
• Timing of Option Exercises: Timing the exercise of stock options to maximize tax efficiency can be crucial. Employees can choose to exercise options when their income is lower, potentially reducing their overall tax liability. This strategy can help manage the tax impact and ensure employees take full advantage of their equity compensation.

Conclusion

Understanding the tax implications related to equity is crucial for startup founders like you. Proper planning can help you and your early employees optimize equity compensation and minimize tax liabilities.

At Qapita, we make equity management simple and transparent, helping you and your employees stay on top of vesting schedules, stock options, and tax liabilities. Our equity management platform, rated as #1 by G2, offers comprehensive tools for managing CapTables and ESOPs and ensuring compliance with tax obligations. 

With features like equity payslips, employee engagement tools, and scenario modeling, you can effectively manage your company's equity and provide clarity to your team​. Our equity management platform is designed to support the complete equity workflow, from issuance to exit. 

Ready to take control of your equity management? Contact our experts today and unlock the power of ownership for your startup.

Frequently Asked Questions

How does the Qualified Small Business Stock (QSBS) tax benefit work for startup founders? 

Under the QSBS tax incentive, founders can defer up to $10 million or 10 times their initial investment in capital gains from selling QSBS shares held for at least five years. This encourages investment in small businesses by significantly reducing the tax burden on long-term gains.

How can founders minimize their tax liability on equity compensation? 

Founders can minimize tax liability by utilizing strategies like deferred compensation plans, the early exercise of stock options, and filing an 83(b) election for restricted stock. These methods help manage tax obligations more effectively and take advantage of lower tax rates.

What are the tax consequences of a startup merger or acquisition for founders? 

In a merger or acquisition, founders may face capital gains tax on the sale of their equity. The tax consequences depend on whether the transaction is structured as a tax-free reorganization or a taxable event. Proper planning and consultation with tax professionals are essential to navigate these complexities.

How does the Alternative Minimum Tax (AMT) affect founders' taxes on equity? 

The AMT ensures that high-income individuals pay a minimum amount of tax, regardless of deductions and credits. For founders, this can impact the tax benefits of equity compensation, as certain deductions may be disallowed, potentially increasing their overall tax liability.