In the nascent days of a startup, stock options are the norm. Early employees can expect access to incentive stock options (ISOs), and non-qualified stock options (NSOs), which are leveraged type options that can make someone very wealthy, very quickly. But as a company matures, there are practical and accounting reasons for phasing out stock options in favor of restricted stock units (RSUs). RSUs are an important component of high-tech compensation packages. Most think of more mature companies providing RSUs, but more and more pre-IPO companies are issuing RSUs.
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Under a conventional RSU plan, the company grants RSUs and vests them over a period, usually four or five years. As the vesting occurs, shares are transferred to the employee. Since RSUs are included in wages, upon transfer, the company will withhold shares to cover the taxes at a federal supplemental income tax rate of 22%, for those making less than $1 million, and pay associated payroll taxes. Those that make more than $1 million have a supplemental rate of 37%.
What happens if your tax rate is significantly higher than 22% but you make less than $1 million? Some companies will allow employees to use their wage withholding rates. However, this is rare due to the way RSUs are coded in the payroll system. This means that employees either need to make quarterly payments or increase their withholding on their regular wages the rest of the year. Most pull the extra money needed by selling some additional shares of the newly acquired stock and paying quarterlies.
By now, you have probably figured out the issue with pre-IPO stocks and RSUs. If you can’t sell the stock, then how can you cover all of the taxes? The answer is that you can’t, which is why pre-IPO companies that have RSUs tend to use double-trigger RSUs. Unlike their conventional cousins, the double-trigger RSU requires two events to occur for the RSUs to vest, and thus become taxable.
The first trigger is the time trigger. Like the publicly traded RSU, there is a vesting schedule that applies usually over a four- or five-year period. However, vesting is still not completed even after five years. The second trigger then becomes crucial, since it requires a liquidity event. This could be an IPO, a DPL, or an acquisition. Whatever that event is, when it happens, all of the stocks that have already been otherwise vested now become transferred in one fell swoop. Does this mean you go to the club to make it rain? No, it means you go to your CPA to find out how much you still owe in taxes.
The timing of it all can be quite tricky. What if the stock vests the day the company goes public? The company will still withhold the 22% as required by law, but what about the additional tax you owe? Many underwriters of IPOs require that insiders and employees wait six months to sell their shares, called a lock-up period. Even though you owe the additional tax on IPO day, you can’t get the additional cash to pay that tax until at least six months later. Even then, those with insider information may still be precluded from selling due to rules at the SEC.
The tax must still be paid, but thankfully, there are other options. Depending on the size of the liability and the state of your budget, you could adjust your withholding to cover the additional liability. If you have other taxable holdings, you could take a margin loan, pay the tax, and then pay yourself back the next time a window to sell opens. You could take a collateralized loan from a third party. The interest rates won’t be favorable, but if you don’t have any other options, it’s a possibility. Finally, depending on prevailing interest rates, it may make the most amount of sense to pay the underpayment penalty and interest on your tax liability.
To compound matters, if the bump from the RSUs is big enough, it may end up kicking you up to a higher tax bracket. The lump sum vesting on the second trigger can be a bitter pill to swallow. The silver lining is that you may be able to exercise additional ISOs with little to no AMT cost. Since all of the income from RSUs is ordinary, it will lead to a greater than normal regular tax, thus there will be room in the AMT to recognize the bargain element for the ISOs.
Whatever your tax situation, it is important to do tax projections and calculate the correct amount of tax that will be owed. A good tax projection will also be your guide to maximizing your AMT. Taxes, especially in an IPO year, can get complex quickly; browse our best resources on taxes below: