For employees who own equity in their companies, the approach of IPO day is filled with excitement. Along with the possibility of newfound wealth, however, comes the prospect of a sizeable tax bill. If your company is on the path to public offering, you may be wondering how this event will impact your tax liability. As with most questions about the IPO process, the answer to this is complex. Before it can be answered, you need to know what kind of equity you have in your company. In most cases, however, IPO day is not a taxable event for pre-IPO shareholders.
What type of employee equity do you have?
What makes this question complex is that there are several types of company equity that employees might be offered. A single company might even issue more than one type of employee equity. Below are descriptions of the main types of equity you might own:
Stock options are a common type of equity compensation. Stock options are not shares. Rather, they represent the option to purchase shares at a specified price. There are two types of employee stock options: nonqualified stock options and incentive stock options.
A company may grant nonqualified stock options (NSOs) to its employees as well as others who provide service to the company, such as vendors, contractors, advisors, and directors. When an NSO is exercised, the price paid (also called the strike price) is subtracted from the equity’s fair market value to determine the bargain element of the transaction. This bargain element is taxed as wages at the time of exercise.
Incentive stock options (ISOs) are a tax-advantaged type of stock option that a company may offer only to its employees. When an employee exercises ISOs, the bargain element is not included in regular income tax. However, it is included in calculation of the alternative minimum tax (AMT). To receive this special tax treatment, ISO shares must be held for at least one year after granting and two years after exercise.
For both NSOs and ISOs, the difference between the sale price and the fair market value at the time of exercise is typically treated as capital gain (or loss) for federal tax purposes (except in instances where ISOs are disqualified).
Employee Stock Purchase Plan
An employee stock purchase plan (ESPP) allows employees to buy shares of stock at a discount with after-tax payroll deductions. These deductions are taken over the course of the offering period until the purchase date, when the accumulated funds are used to purchase shares in the company. The bargain element of an ESPP, however, is not taxable until the employee sells the shares, at which time it is taxable as ordinary income. Any remaining gains are taxed as capital gains.
Restricted Stock Awards
Restricted stock awards (RSAs) are grants of company stock that typically vest over the course of several years. The fair market value of shares, minus any price paid for them, are taxed as ordinary income as they vest. Any additional gains from the sale of these shares are treated as capital gains.
Restricted Stock Units
Restricted stock units (RSUs) are treated as wage income. As they vest, shares are transferred to the employee, and the employer must withhold 22% of their fair market value (37% for employees earning more than $1 million) for taxes. Single-trigger RSUs vest after a single event occurs (typically, time in service to the company). Because many employees earning less than $1 million will owe more than 22% in taxes on their income, it’s important to plan for this difference. This may involve having the employer take additional withholding and/or making estimated tax payments throughout the year.
Double-trigger RSUs present a more difficult problem. This type of RSU doesn’t fully vest until a second event occurs: the company’s public offering. This is the case where an IPO can be a significant taxable event for employees. Because double-trigger RSUs can vest all at once, employees can experience a sizeable bump in income for a single tax year. This can create a significant hardship for these employees since the lockup period prevents them from selling shares to cover the under-withholding.
How can you limit your tax liability?
If available, consider an 83(b) election.
In the case of stock options and RSAs, filing an 83(b) election may reduce the amount of taxes you owe. Filing an 83(b) fixes the fair market value of equity for tax purposes at the time of filing (or, in the case of options, at the time of early exercise). Since share value tends to increase over time, this move can create a tax benefit by keeping the bargain element of the transaction relatively low. Of course, share value can also fall, and if this happens, any excess tax paid as a result of the filing is not refundable. Therefore, it’s important to consult a trusted fiduciary investment advisor before deciding whether to file an 83(b). RSUs are not eligible for 83(b) election.
Pay attention to holding periods.
Short vs. Long-Term Capital Gains
When you sell your company shares, how much you pay in taxes will depend, in part, on whether the sale will be subject to short- or long-term capital gains. To qualify for the lower long-term capital gains rate, you will need to hold your shares for at least one year before selling them.
Disposition of ISOs
If you had ISOs, you will also need to hold these shares for at least two years after the date your options were granted. Selling them before this date results in a “disqualifying disposition,” which removes the beneficial tax treatment they receive.
Qualified Small Business Stock
Under certain conditions, gains from the sale of qualified small business stock (QSBS) may be exempt from federal taxes. To qualify for this exemption, the stock must be held for at least five years. The rules for QSBS are complex, however, and apply to both the granting company and the shareholder. If you think you may hold QSBS, talk to a knowledgeable tax professional to understand how to make the most of this opportunity.
Work with a fiduciary advisor who understands the IPO process.
The IPO process is complex, and navigating it improperly can be costly. An investment professional with experience assisting employees in pre-IPO companies will be an invaluable asset. To learn more about what you should know about your company’s public offering, subscribe to the WRP blog or check out our library of free online resources.