Proposed in the U.S. Senate - Changes to Startup Employee Equity Taxation - CEO and Worker Pension Fairness Act
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
If national politics take a strange turn and an unlikely new tax bill proposed in the U.S. Senate last month becomes law, individuals can expect a huge tax hit on NQSOs and startup RSUs. NQSOs would become taxable at vesting on the spread between the exercise price and the FMV. Currently, the exercise - rather than the vesting - of a NQSO is the taxable event. RSUs would become taxable at their FMV when time-based service milestones are achieved. Currently, taxation on RSUs in specially-designed private company plans (such as Airbnb and Pinterest) is deferred until an IPO or company acquisition.
There is an exception in the bill for those grants that qualify for Section 83(i) - which was intended to allow for deferral of taxation on private company stock until it becomes tradeable. But Section 83(i) as enacted is very limited and not workable in practice. Therefore, startup employees can expect that their NQSOs and RSUs - as they are currently designed - would be taxable even if they are not able to sell the shares to cover the tax bill.
So what will happen in practice? Startup employees with valuable equity grants would either pay high taxes out of their own savings (if they have them) before their shares are tradable or walk away from valuable equity opportunities to avoid this tax expense.
This would also change the world of equity compensation design, as tax is the underlying rhythm of all employee equity. The best practices as of today would become obsolete. In practice, I predict that this bill would result in an unexpected and very anti-employee consequence in future equity compensation design: more company clawbacks on time-vested shares.
More clawbacks? The same clawbacks that experts have called “horrible for employees” and encouraged people to “run screaming from” in a job offer? Yes. A clawback is the right of a company to take back time-vested shares if an employee leaves the company prior to an acquisition or IPO. This term dramatically reduces the value of startup equity, as most individuals who work at startups in the early stages do not stay at those startups all the way until the acquisition or IPO.
Why would more clawbacks be the result of this proposed bill? If companies design their NQSOs and RSUs so that employees are required to remain in service until the later of the date of an acquisition/IPO or their time-based vesting schedule, those employees would not be taxed under this new bill when they meet their time-based vesting requirements. In that workaround, though, employees would forfeit their time-vested shares if they leave the company prior to the acquisition or IPO. That means that employees would have to stay in service until that exit event to have a payout and, therefore, that far fewer early stage employees would have paydays in startup acquisitions and IPOs.
It would be hard to believe that these are the results intended by the bill, but from my perspective this is the most likely outcome for employee equity grants. Thoughts?
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
