Proposed GOP Tax Bill Could Drastically Affect the Treatment of Stock Options
The current version of the House GOP tax bill, the “Tax Cuts and Jobs Act”, which was first introduced last week, proposes two big changes to the treatment of stock options, one that will likely be viewed positively by the startup community and one that will not.
Specifically, the two proposed changes in the bill are as follows:
- A new section, Section 409B, that requires non-qualified stock options be taxed upon vesting rather than upon exercise.
- New language that would defer any taxes upon the exercise of qualified stock options and restricted stock units for up to five years, so long as the issuer is not publicly traded.
If these proposed changes are included in the final bill, and more importantly if that bill is actually passed, they could have long-standing effects on the treatment and usefulness of stock options as equity incentives to employees, advisors, and other service providers.
Tax upon “Vesting” NOT upon “Exercise”
Currently, individuals who have been issued options, whether qualified or non-qualified, do not incur any tax obligations from such options until such options are exercised. Individuals who hold non-qualified options are able to defer the recognition of any “ordinary income”, which is calculated as the difference between the exercise price and the fair market value (“FMV”), until such options are exercised. On the other hand, subject to a caveat regarding the Alternative Minimum Tax (“AMT”) discussed below, individuals who hold qualified options are not required to recognize any “ordinary income” at the time of exercise, but rather are able to defer such recognition until such individual is able to actually sell the stock.
In a drastic paradigm shift, proposed Section 409B would require that such individuals holding non-qualified options recognize “ordinary income” at the time that such options vest rather than allowing them to defer this recognition until they actually exercise the options.
The specific proposed language for Section 409B is “[a]ny compensation which is deferred under a nonqualified deferred compensation plan shall be includible in the gross income of the person who performed the services to which such compensation relates when there is no substantial risk of forfeiture of the rights of such person to such compensation.”
What this means is that individuals who receive non-qualified stock options will be taxed on the difference between the FMV and the exercise price at the time that such stock options vest, whether or not such person has actually chosen to exercise such options. You will often see this referred to as a person being taxed purely on “unrealized” or “paper” gains. The particularly concerning result of this regulatory framework is that the risk of future price fluctuations is now borne by the option holder.
Thus, proposed Section 409B could severely minimize the value of non-qualified stock options as part of compensation packages. If enacted, companies and employees will need to closely scrutinize their current equity incentive plans and severance packages to ensure that they are structured to most effectively deal with the repercussions of Section 409B.
Deferment of Option Income for Private Company Employees
As hinted at above, there is currently a unique kink in the tax code when it comes to the taxation of qualified stock options. While holders of qualified stock options are not required to recognize any “ordinary income” until they sell such stock, the difference between the FMV and the exercise price at the time that such stock option is exercised does count towards the calculations of AMT for such holder. Given that the employees who are receiving qualified stock options typically do not have the cash on hand to cover such AMT liability, the practical effect of this rule is that most employees do not exercise any of their qualified stock options until there is a liquidation event. Further, as employees are not exercising their stock options until right before a liquidation event, such employees are having to pay taxes on the sale of such stock at the full tax rates, rather than the beneficial capital gains rates because they have not owned such stock for the requisite holding period of one year.
While not in the original version of the bill, Kevin Brady, the Chairman of the House Ways and Means Committee, proposed an amendment to the House GOP tax bill that included an amendment to defer any income from the exercise of qualified stock options for up to five years, so long as the company issuing the stock is not a public company.
Given that the proposed tax plan also proposes to terminate the AMT, qualified stock options would become far more attractive as equity incentive instruments for employees of private companies if this amendment is included in the final bill, and if such bill is passed. This amendment would also definitively pull the taxation of any qualified stock options outside of the purview of the proposed Section 409B and, thus, employees would be able to exercise their qualified stock options when vested and start the capital gains rate clock without incurring any tax liability.
This would particularly help those cash-strapped, early employees of startups who want to exercise their stock options in preparation for that big exit!
Please be aware that the House GOP tax bill is still very much in flux. We will continue to monitor the bill and provide updates on key developments as the bill goes through the legislative process.
Scannavino Lamb LLP is a boutique law firm based in New York City offering legal and strategic advice to forward-thinking entrepreneurs, startup companies, and startup investors. Founded by former Big Law lawyers with a range of experience in corporate law and business transactions, the firm serves its clients by blending world-class service with entrepreneurial perspective. Check us out at www.scannavinolamb.com.
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