EDUCATION

Taxes: The Ins and Outs of Taxes for Equity Compensation

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With tax season looming, tax rules affecting equity compensation hit close to home.

When it comes to taxing equity, 3 considerations determine what you owe:

What kind of equity you have
When you choose to pay
When you choose to exercise

Before we dig into the way that taxes work for each type of equity, let’s review the types of taxes relevant to equity compensation

Ordinary Income Tax: Tax owed on any income earned by an individual. As of the 2021 tax year, there were seven brackets, ranging from 10%-37%, depending on your taxable income and filing status (single, married, etc.). The ordinary income tax rate is the same as the short-term capital gains rate (see below) applied to the sale of assets held for less than 1 year.

Long-Term Capital Gains Tax: Tax owed on the profits from the sale of most investments (stocks, collectibles, investment real estate) if held for at least one year. The capital gains tax rate is 0%, 15%, or 20%, depending on your taxable income for the year. There is value to holding onto assets that you believe will be successful in terms of equity (i.e. the lower taxes and greater payout if the organization does increase in value)

Alternative Minimum Tax (AMT): A tax system that expands the amount of income that is taxed by adding items that are usually tax-free and disallowing many deductions under the regular tax system. The AMT does not apply to everyone, but is relevant to exercising some types of stock options. The AMT is in play when you exercise Incentive Stock Options (ISOs), hold onto them, and sell them after the calendar year they were awarded to you. In essence, it is a tax on the hypothetical profit you would have made if you sold the stock on the day you purchased it. It is processed through Form 6251, available through the IRS here. More about this below.

To better understand how these tax brackets work, see the following examples:

Note: These determinations are based on the IRS Federal Guidelines for 2021. For more information, see here.

Person A has a yearly income of $90,000 and files their taxes with their married spouse who makes $75,000 per year (married, filling jointly). Person A is in the 22% ordinary income tax bracket (paying $9,328 plus 22% of the amount over $81,050) and the 15% long-term capital gains bracket.
Person B has a yearly income of $200,000 and files their taxes by themselves. They are in the 32% ordinary income tax bracket (paying $33,603 plus 32% of the amount over $164,925) and the 15% long-term capital gains bracket.
Person C has a yearly income of $32,000 and files their taxes by themselves. They are in the 12% ordinary income tax bracket (paying $995 plus 12% of the amount over $9,950) and the 10% long-term capital gains bracket.

As is demonstrated, one’s capital gains tax rate is almost always lower than their ordinary income tax (short-term capital gains rate).

There’s one more concept to understand, the 83(b) election — a provision under the federal revenue code that allows stock recipients to pay taxes on the fair market value (FMV) of restricted stock when granted, rather than when it is sold. This means that individuals whose stock value increases over time will pay less in taxes (fair market value of the stock at present is less than at future).

The 83(b) election does come with its downfalls. For one, the election is irrevocable. That means that once you’ve decided to pursue the election, you owe the taxes, regardless of the actual outcome of the stock value. If, for example, you choose the 83(b) election on restricted stock awards that decrease in value, you will have paid more taxes than you would have without the election. Additionally, you should be aware of the termination policy around your equity - if for example, you leave the company after choosing the 83(b) election, but before your stock fully vests, you might not ever actually own the stock but will have paid taxes on it anyway.

If this feels a bit confusing, don't worry. Below we will elaborate on each type of equity

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Restricted Stock Awards

Say you are granted 100 shares of restricted stock awards on April 1st, 2021, worth $15 per share and vests over 4 years. Once it’s vested it’s worth $25 per share.

Note: This scenario - which we will use throughout the following examples - assumes the company will grow overtime

For this example, we will assume you are in the 35% Ordinary Income Tax bracket and 15% Long-Term Capital Gains Tax bracket

You have two options:‍

1. Take the 83(b) election

At Grant: By taking the 83(b) election you’ll owe ordinary income tax on the purchase, $15 x 100 = $1,500 x 35% = $525

At Vest: None

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2. Don’t take the 83(b) election

At Grant: None

At Vest: Without the 83(b), you’ll owe ordinary income tax on the fair market value at vest, $25 x 100 = $2500 x 35% = $875

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The taxes on the sale of Restricted Stock Awards are the same regardless of whether an 83(b) election was made:

Held for less than 1 year: Ordinary income tax (including immediate sale)
Held for more than 1 year: Long-term capital gains tax

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Restricted Stock Units (RSUs)

When it comes to Restricted Stock Units, taxes are approached differently depending on whether the company is public or private.

Because with RSUs there is no actual stock issues at grant, there is not a Section 83(b) election opportunity.

Public Company

Let’s look at the same example from last time - 100 shares of RSUs on April 1st, 2021 that vest over 4 years, first vesting date (April 1st, 2022).

For this example, we will assume you are in the 35% Ordinary Income Tax bracket and 15% Long-Term Capital Gains Tax bracket

At Vest: Each portion of vested shares is taxable on its vesting date as ordinary income when the shares are delivered

Year 1: Stock price at vesting is $25, 25 shares x $25 = $625
Year 2: Stock price at vesting is $27, 25 shares x $27 = $675
Year 3: Stock price at vesting is $34, 25 shares x $34 = $850
Year 4: Stock price at vesting is $34, 25 shares x $34 = $850

You’ll owe ordinary income tax on the shares, total = ($625 + $675 + $850 + $850) $3,000 x 35% = $1,050

At Sale: Depending on how long you hold your shares, there are different taxing protocols

Held for less than 1 year: If you decide to sell your 100 shares a few months later for $45 per share, then you will owe taxes on the difference at the Short-Term Capital Gains Rate (or the Ordinary Income Tax Rate) of 35%, $45 x 100 shares = $4,500 - $3,000 = $1,500 x 35% = $525. Total Taxes = $1,050 + $525 = $1,575

Held for more than 1 year: If you decide to sell your 100 shares over a year later for $45 per share, then you will owe taxes on the difference. $45 x 100 shares = $4,500 - $3,000 = $1,500 x 15% = $225. Total Taxes = $1,050 + $225 = 1,275

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Private Company

Similar to a public company, RSU shares are delivered once they vest. However, for a private company RSUs have “double-trigger” vesting, meaning that two events are requires before the employee owns the shares:

Time-Based Vesting (x amount of months or years)
Change in control (like an acquisition) or liquidation event (like an IPO)

Thus, shares in a private company don’t vest just at the time-based vest (first trigger), they are delivered at the first liquidity event or change in control (double trigger).

Taxes are calculated based on the fair market value of the stock at the time of the first liquidity event.

Note: This is often higher than the value of the shares at the time-based vesting (i.e. 100 shares of RSUs that vest over 4 years. At year 1 = $8, year 2 = $8, year 3 = $8, year 4 = $9. The company goes public at $14/share. You will be taxed on the shares at the double-trigger vest price of $14/share)

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Stock Options

Taxes for NSOs

At Exercise: Taxed as regular income, not eligible for the 83(b) election. Taxes are based on the spread between the stock's Fair Market Value when it is purchased (market rate) and the exercise price (or strike price).

At Sale:

Held for less than 1 year: Stock is taxable at the long-term capital gains rate and option grant date is less than two years before the sale
Held for more than 1 year and comes from options granted at least two years prior to the sale: Long-term capital gains tax

Taxes for ISOs

Recall that the Alternative Minimum Tax (AMT) is often applied to ISOs. This comes in the AMT adjustment, applied to the bargain element, or the difference between the exercise price and market price on the day you exercised your options and purchased the stock.

Say you are granted the option to purchase 100 shares of stock on April 1st, 2021 at the strike price of $25. The shares vests over 4 years.

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Let’s go through some potential taxing scenarios based on this opportunity:

‍Scenario 1: At year 2 you decide to exercise 50 shares at your grant’s strike price of $25. The bargain element, which is the $45 Market Price - $25 Exercise/Strike Price = $20 x 50 shares = $1,000 requires an AMT adjustment. You hold these shares indefinitely.‍

‍Scenario 2: At year 3 you decide to exercise the 75 shares that have vested and purchase them at $25. You decide to sell these shares over 1 year later. Note that because this transaction is taking place over a year after the stock is purchased and more than two years after it is granted, the profit is treated as long-term capital gains‍
Sale Price = $48 x 75 shares = $3,600
Cost = $25 x 75 shares = $1,875
The long-term gain is the difference of $3,600 - $1,875 = $1,725
An AMT adjustment is required for this transaction - as the difference between the market price at exercise and exercise price, ($32 - $25) x 75 shares

Scenario 3: At year 1 you decide to exercise the 25 shares that have vested and purchase them at $25. As it pertains to the AMT, there are two outcomes to consider: (Note: This analysis only considers the AMT)‍
Holding onto the shares for the duration of the calendar year - in this scenario you would need to report the bargain element, $28 Market Price - $25 Exercise Price = $3 x 25 shares
Selling the shares within the calendar year - because you bought and sold the shares in the same year, there is no need for an AMT adjustment

To review ISOs:

At Exercise: No tax liabilities are owed for holders of ISOs at the time of exercise.

Potentially owe the AMT that tax year on the bargain element
Can pursue the 83(b) election if early exercising