If you receive equity compensation in your pre-IPO company, you have several important decisions to make before IPO day. In this article, we’ll walk you through various stages of the IPO process and what you need to know at each step to get the most out of your options or restricted stock.
Set goals & take Inventory
The first step in any financial plan is financial goal setting. Only when you have a vision for the future can you chart the most effective course to get there. While you work on solidifying your goals, take inventory of what kind of equity compensation you own and in what amounts. Understanding this is critical for effective decision-making throughout the process.
Employers can offer several different types of equity compensation. You may have incentive or non-qualified stock options, restricted stock, or shares acquired via an employee stock purchase plan. Additionally, depending on the status of your company, your shares may be classified as qualified small business stock. Each of these variables will be important factors in your tax and sales strategies.
If available, consider early exercise & 83(b) election.
If you have stock options or a restricted stock award (RSA), you may be able to claim any taxable gain on the exercise or grant before IPO day. You can do this by filing an 83(b) election with the IRS within 30 days of exercising options or receiving the RSA grant. Not only can this help keep any taxable bargain element as low as possible, but it also starts the clock on waiting periods that must be satisfied to sell your stock and retain applicable tax benefits. Loans are often available to help pre-IPO employees exercise stock options and pay any resulting tax bills.
Wait out the lockup period.
If all goes well, you could see the value of your shares take off after IPO. However, you most likely won’t be able to cash in right away. Most often, IPO and SPAC processes include a lockup period, which prevents pre-IPO shareholders from selling shares for a specified period of time after the company goes public. This often lasts six months but can be longer or shorter depending on the requirements of your company’s underwriter or acquiring company.
Plan for blackout periods.
Even after the lockup period expires, your ability to sell can be limited by blackout periods. Intended to prevent illegal insider trading, blackout periods prevent those who possess material non-public information about a company from trading that company’s shares. If you’re an executive or key employee, you may be subject to more blackout periods than other employees by virtue of your heightened access to non-public information.
Fortunately, in August 2000, the U.S. Securities and Exchange Commission (SEC) adopted Rule 10b5-1, providing pre-IPO shareholders a way to sell shares during blackout periods while avoiding the appearance of illegal insider trading. The rule allows these shareholders to create a legally binding trading plan (called a 10b5-1 plan) when they are not in possession of material non-public information about their company. 10b5-1 plans have to meet strict legal requirements, but they can utilize complex algorithms to determine trades rather than specifying concrete times, dates, and limit prices.
Minimize your tax obligation.
Several factors contribute to how your equity compensation will be taxed. Below are some key concepts for understanding your tax obligation and how to keep it as low as possible.
When is the bargain element taxable?
When you receive equity compensation, the difference between any price you pay and the fair market value is the bargain element of the transaction.
- For non-qualified stock options (NSOs) and RSAs, this bargain element is subject to ordinary income tax at the time you exercise the options or receive the RSA.
- For incentive stock options (ISOs), the bargain element is reportable for the alternative minimum taxcalculation at the time of exercise.
- If you purchase shares through an ESPP, the bargain element is tax free as long as applicable holding requirements are met.
What holding periods apply?
Generally speaking, investments must be held longer than one year to get long-term capital gains treatment, which can result in a significantly lower tax bill than short-term capital gains. Certain types of equity compensation have additional holding requirements that must be met to take full advantage of their tax benefits.
- If you have ISOs, you must hold them for more than two years after the grant date to retain their favored tax status; selling them before this date subjects their bargain element to ordinary income tax.
- ESPP shares must be held more than two years after the offering date to retain tax exemption for the bargain element.
- QSBS that’s held for at least five years could be fully excluded from federal tax.
Can you offset taxable gains?
As you sell your shares, a tax mitigation strategy is crucial. An experienced tax and investment advisor can help you implement tax alpha strategies that allow you to systematically reduce your concentrated position over time with less tax burden. Carefully crafted gifting strategies can also help you reduce your tax bill while supporting people and charities you care about.
WRP Wealth Management specializes in helping pre-IPO employees successfully navigate the IPO process. For more tips on making the most of your company’s IPO, browse our blog or our free resource library.