As your company’s public offering date approaches, preparation is everything. To take full advantage of this rare financial opportunity, it’s critical to understand exactly what type of options and/or equity you have, the tax implications they carry, and when you’ll be able to sell your shares. In this article, we’ll discuss some of the important steps to take on the road to your company’s IPO.
What kind of equity compensation have you received?
Companies that anticipate going public may offer their executives and employees equity compensation in a variety of forms. The first step in preparing for your company’s debut on the public markets is to understand exactly what type or types you have.
- Non-qualified stock options (NSOs) can be offered to company employees as well as others such as vendors, contractors, and consultants.
- Incentive stock options (ISOs) are a tax-advantaged form of equity compensation that companies may make available only to employees.
- Restricted stock awards (RSAs) are grants of company stock. Employees are allocated shares as of the grant date, but vesting occurs according to a schedule, usually over the course of several years.
- Restricted stock units (RSUs) are grants of rights to acquire company stock after specified vesting conditions are met. Legal ownership of shares is transferred to employees as they vest.
- An employee stock purchase plan (ESPP) allows employees to buy shares using after-tax payroll deductions. Deductions take place during the offering period and are then used to purchase shares on the purchase date.
How do taxes impact receipt of your equity compensation?
The type of equity compensation you’ve received determines how you’ll be taxed on it. Understanding the tax treatment of your options or shares is essential to getting the most out of them through effective tax planning. Below are some key tax considerations for these various types of equity.
If you have non-qualified stock options, you’ll be taxed on the bargain element (the fair market value minus the strike price) at the time of exercise. Because the bargain element of NSO exercise is taxed as wages, you must be prepared to pay the tax bill when you exercise these options. When you sell NSOs, any additional gain is subject to capital gains tax.
Because of their favorable tax treatment, incentive stock options can make it easier for employees to buy into their companies. At exercise, the bargain element of ISOs is not included in ordinary federal income tax calculations. It is, however, includable in the alternative minimum tax (AMT) calculation. For this reason, it’s important to make yearly income projections when planning ISO exercise; this provides insight into when the AMT will be triggered and how you can time the exercise of options to minimize the tax impact. If you meet the withholding requirements (more below) additional gains are taxed at the time of sale at applicable capital gains rates.
Restricted stock awards receive similar tax treatment to NSOs; as they vest, the fair market value of the underlying shares, minus any price paid for them, is taxed as ordinary income.
The value of restricted stock units is treated as ordinary income at the time of vesting. The impact of this, however, depends on the type of vesting schedule used. Single-trigger RSUs vest according to a schedule, which spreads the tax obligation out over the course of this vesting schedule. Double-trigger RSUs, on the other hand, have two vesting requirements: a time-in-service requirement in addition to the company’s liquidity event. This can present a significant problem for double-trigger RSU holders, as they can be hit with a tax bill for a large number of shares on IPO day.
The bargain element of ESPP purchases is not taxable until shares are sold. At that time, the bargain element is subject to ordinary income tax, and additional gains get capital gains treatment, so long you meet the holding requirements (more below).
ESPP Holding Period Requirements
An employee stock purchase plan (ESPP) allows employees to buy shares using after-tax payroll deductions. Deductions take place during the offering period and are then used to purchase shares on the purchase date. It's important to note that ESPPs have holding period requirements that must be met before you can sell your shares for a profit.
The holding period for ESPPs has two parts: the first holding period and the second holding period. The first holding period begins on the first day of the offering period and ends on the purchase date. The second holding period begins on the purchase date and ends on the later of two years from the beginning of the first holding period or one year from the purchase date.
During the first holding period, you cannot sell or transfer your shares. However, you can sell or transfer your shares during the second holding period, subject to certain conditions. If you sell your shares before the end of the second holding period, you may be subject to a disqualifying disposition, which could result in additional taxes.
It's important to carefully review your company's ESPP plan and understand the holding period requirements before you participate. By doing so, you can plan and make informed decisions about when to sell your shares and potentially avoid additional taxes.
Can you utilize Section 83(b)?
RSA holders and some stock option recipients can potentially minimize the tax impact of vesting or exercise. Section 83(b) of the Internal Revenue Code allows these investors to claim the value received before their shares vest. This can result in tremendous tax savings because the fair market value of shares is typically much lower when granted.
To take advantage of this benefit, RSA holders must make an 83(b) election with the IRS within 30 days of the grant date. If the issuing company allows early exercise, owners of stock options must first exercise their options. They then have 30 days from the exercise date to file an 83(b) election. Before exercising options early or filing an 83(b) election, however, it’s important to understand the financial risk you’re taking and have a plan to pay the tax bill that will result.
When will you be able to sell your shares?
The overriding purpose of any investment is to help you meet your financial goals. To create a comprehensive plan to turn your investment opportunity into your dreams for the future, you must understand when you’ll be able to cash in and sell your shares. Because this can be a long process, careful planning is critical.
Lockup & Blackout Periods
Most of the time, pre-IPO shareholders are not allowed to sell their shares on IPO day. That’s because IPO underwriters and SPACs typically require a lockup period, which often lasts six months to a year. Additionally, those who possess material, non-public information about a company are prohibited from trading shares. Because of this, executives and employees are often subject to blackout periods at key times, such as immediately before earnings reports. Executives and upper-level managers may be more limited by blackout periods because of their heightened access to material, non-public information. A 10b5-1 trading plan, which can be created when you’re not in possession of such information, provides a way to make prescheduled trades in spite of blackout periods.
Understanding the holding periods that apply to your shares is essential to getting the best possible tax treatment. In general, investments must be held for more than one year to receive long-term capital gains treatment. Because long-term capital gains rates are considerably lower than short-term rates, it’s most often beneficial to hold appreciated shares for at least a year.
To retain their favorable tax treatment, ISOs must be held at least two years after their grant date. Selling ISOs before this time is a disqualifying disposition, which converts them to NSOs. In this event, the bargain element of the ISO purchase, which was originally excluded, becomes subject to ordinary income tax.
Qualified small business stock (QSBS) receives special tax treatment to incentivize investment in small businesses. If your shares meet QSBS guidelines, the sale of your shares could be completely exempt from federal taxes. To receive this benefit, however, you must hold QSBS shares for at least five years, among other requirements.
If your company’s liquidity date is approaching, you have no time to lose. Making the most out of your employer’s IPO requires careful planning and a team of experts to guide you through the intricacies of financial, investment, and tax planning. WRP Wealth Management specializes in assisting executives and employees at pre-IPO companies as they navigate this complex process. For more tips on preparing for the big day, subscribe to our blog.