A recently passed House bill would permit certain start-up employees to defer taxes on stock options and restricted stock units (RSUs).  The proposed legislation aims to help emerging companies attract and retain talent by offering equity compensation on more attractive terms.

Business Taxation
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Cash-strapped start-ups often grant an ownership stake to employees to compensate for below-market wages.  This strategy also aligns incentives by giving employees a share of the company’s growth.

However, current tax law makes such equity compensation less attractive than it might otherwise be.  When employees exercise their stock options or when RSUs vest, they must pay taxes on the excess difference between the current fair market value and the purchase price.  Of course, the employee hasn’t actually pocketed any cash.  So the income is “phantom” income, but the tax burden is real.  Public company employees have the option to sell shares on the open market, but there is typically no market for private company stock.  Employees must choose between paying taxes out of pocket or foregoing their ownership stake.  This Hobson’s choice can dilute the value of equity compensation, making it more difficult for emerging companies to attract top talent.

The Empowering Employees through Stock Ownership Act (the “Act”) seeks to alleviate this tax burden on illiquid income.  Qualified employees working at eligible companies could defer paying taxes on income from qualified stock for up to 7 years.  Let’s unpack those terms:

  • Qualified Employee:  To take advantage of the tax deferral, employees must be “qualified employees”.  This includes all employees except certain owners and officers:  owners of 1-percent or more of the company, certain executives (CEO, COO or individuals acting in such capacity), and the company’s four highest earning officers are excluded.
  • Eligible Companies:  The Act is intended to incentivize broad-based employee ownership.  If a company wants its employees to qualify, it must have a written plan under which at least 80% of all U.S. employees who provide services to the company are granted stock options or RSUs on an annual basis.  The company must also offer stock options or RSUs to employees on similar terms.  Finally, the company cannot be traded on an established market.
  • Qualified Stock:  Qualified stock includes stock received in connection with the exercise of a stock option or vesting of a RSU.  The stock must be received as compensation for services performed as an employee of the company.  Importantly, stock is not qualified if the employee has the right to sell the stock to the company at the time of exercise or vesting or to otherwise receive cash in lieu of the stock.
  • 7-Year Deferral:  Employees are currently required to pay taxes in the year in which they exercise stock options or their RSUs vest.  Under the Act, employees would not have to recognize (or pay taxes on) this income until 7 years after exercise or vesting.  Certain triggering events could cause employees to have to pay taxes prior to the 7-year anniversary:  if the stock becomes transferable (including to the employer), if the employee becomes an excluded employee, if the stock becomes tradeable on an established market, or if the employee revokes the election.

Despite some controversy over how this tax deferral will be paid for, the Act is generally receiving praise as a move to strengthen the economy and create jobs by helping early stage companies attract the talent that will help them succeed.