Taxation of Stock Awards & Stock Bonuses

Stock Awards & Stock Bonuses

I am frequently asked how stock awards are taxed in the context of a private company issuing stock to employees or contractors as a work incentive.

The Taxation of Stock Awards and Stock Bonuses

Here is a short summary:

1) If the stock award is an award of fully vested shares, then the recipient of the award is taxed when he or she receives the shares, based on the value of the shares at that time.

2) If the shares are not vested, the recipient of the award is either:

–taxed on the receipt of the shares based on the value of the shares at the time of receipt, if the recipient makes an 83(b) election; or

–the recipient is taxed when the shares vest, based on the value of the shares when they vest. The trouble with not making the 83(b) election and waiting to be taxed is that when the shares vest they may be worth a lot more than when they were awarded. This can result in the recipient owing more in tax than the recipient can pay.

Here is how Fred Wilson described it:

The one downside to restricted stock is you have to pay income taxes on the stock grant. The stock grant will be valued at fair market value (which is likely to be the 409a valuation we discussed last week) and you will be taxed on it. Most commonly you will be taxed upon vesting at the fair market value of the stock at that time. You can make an 83b election which will accelerate the tax to the time of grant and thus lock in a possibly lower valuation and lower taxes.

This taxation issue is the reason most companies issue options instead of restricted stock. It is not attractive to most employees to get a big tax bill along with some illiquid stock they cannot sell. The two times restricted stock make sense are at formation (or shortly thereafter) when the value of the granted stock is nominal and when the recipient has sufficient means to pay the taxes and is willing to accept the tradeoff of paying taxes right up front in return for capital gains treatment upon sale.

Employee Withholding

If the recipient is an employee, then the employer has to withhold income and employment taxes from the employee. This means the employee will have to write a check to the employer upon the taxing of the award.

The taxing of the award can happen either at the time of grant or upon vesting. Therefore, an employer has to have a system in place to enforce the withholding obligation. The employer also has to monitor 83(b) elections.

What If Employee Pays FMV for the Shares?

Sometimes people think that if an employee or service provider has paid fair market value for the shares that somehow the tax problems go away. This is the case if the shares are fully vested upon purchase, and the employee paid fair market value for the shares.

But if the shares are subject to vesting the tax problems are not over. If the employee does not make an 83(b) election within 30 days of receiving the shares, then the employer will have a tax withholding obligation on vesting.

What Should You Do?

Just like Fred said, taxes are the reason most employees wind up with options. Congress could fix this problem. It seems to me that it would be very pro-worker legislation to provide that gross income does not include the receipt of shares in a private company.

General Disclaimer/Warning

Please be aware that this article is a general summary. If you are considering your personal situation, know that your documents may not be standard documents, and the summary above may not accurately apply to your personal situation.

Taxation of Restricted Stock Units

I have been receiving a lot of questions about RSUs. I think this is because a lot of large public tech companies use RSUs rather than stock options.

For a variety of reasons, RSUs do not translate well to the startup company arena. I discuss this below. But first, let’s summarize some key facts about RSUs. 

What Is a Restricted Stock Unit?

An RSU is a contractual promise on the part of a company to deliver shares to a service provider after the fulfillment of vesting conditions.

For example, a service provider might get 100 RSUs, vesting after 1 year of service. After 1 year, the company would issue 100 shares of stock in fulfillment or settlement of the RSU.

Can an 83(b) Election Be Made On the Receipt of an RSU?

An 83(b) election cannot be made on the receipt of an RSU. The reason for this is because the RSU is merely a promise on the part of a company to issue stock later upon the fulfillment of vesting conditions. An RSU is not an award of stock.

Is an RSU Taxable Upon Receipt?

An RSU is not taxable upon receipt because all that is given is a promise on the part of a company to deliver shares later if vesting conditions are met.

Is an RSU Taxable Upon Vesting?

When an RSU vests and shares are delivered, the shares are taxable. The value of the shares at that time is taxed just like ordinary income wages or salary or independent contractor payments.

How Does an RSU Compare to Other Types of Awards?

An RSU is different from a stock option and a restricted stock award in a number of key respects.

I have summarized the differences in the table below. As you can see from the table below, for early stage companies, options or restricted stock is typically better than an RSU.

Table Summarizing Some of the Differences in Award Types

Restricted Stock Units Restricted Stock Awards Stock Options
Taxation at Grant? No Yes, if vested or an 83(b) election is made No, as long as priced at fair market value
Taxation Upon Vesting? Yes, because usually shares are delivered upon vesting; and there is ordinary income at that time at the then value of the shares. Yes, if subject to vesting and no 83(b) election was made No, as long as priced at fair market value
Taxation Upon Settlement or Exercise? Yes, ordinary income at that time at the then value of the shares. No concept of exercise with a restricted stock award Yes, but exact consequences depend on whether an ISO or NQO

What Don’t RSUs Fit In Early Stage Companies Very Well?

  • An early stage company’s shares are not liquid. When you receive them, you can’t sell shares to pay the tax. This is not the case for public companies.
  • Early stage company’s frequently do not have the cash reserves to help their employees pay their taxes. Large profitable companies will sometimes withhold shares from employees on the vesting of an RSU to satisfy the tax withholding. This only works though if the company has the cash to pay the taxes. See this article on Facebook.
  • For private companies that anticipate an IPO in the foreseeable future, RSUs can make sense. But this is not the case for a lot of early stage companies, where restricted stock awards or options are going to make the most sense.

Generalized Warning/Cautionary Statement

It is always advisable to consult with tax advisors and lawyers in evaluating the particulars of equity incentive award documents. Award documents vary widely in the wild, especially RSU award documents. And this blog post has made simplifying assumptions that may not apply in your particular situation. Good luck and have fun out there!

Taxation of Employee Equity Awards

Sam Altman just wrote a great post on employee equity.

I’ve been writing for a long time that Congress needs to fix the taxation of employee equity–so that companies can more easily share equity with workers.

The way it works now, once a company has more than a very low value, employees can’t afford to have companies transfer them stock because they can’t afford to pay the taxes on the receipt of the shares.

Example

Let me give you an example. Suppose a startup wants to hire me, and that it wants to issue me shares. The startup has performed a valuation analysis and determined that the current fair market value of the shares it wants to issue me is $50,000.

This transfer will cost me a lot in taxes. And if I am going to be an employee of the company, I am going to have to write a check to the company for the income and employment tax withholding on the issuance of the shares. If I am an average worker, I won’t be able to afford the taxes on the receipt of the shares. I’ll have to tell the company, “Please don’t do this.”

Options

Stock options are the most frequently used alternative, but stock options are not perfect for a number of different reasons:

  • stock options generally have to be priced at fair market value on the date of grant to avoid adverse tax consequences to the optionee under Section 409A of the Internal Revenue Code.
  • typical option plans require the option to be exercised within a relatively short period of time after termination of service (e.g., 90 days).

Options do avoid the taxation to the service provider on the receipt of the option if the options are priced at fair market value on the date of grant. That is good news. But on the exercise of the option, if the option is a non-qualified stock option, the employee will have ordinary income on the spread, and will have to write a check to the company to cover the taxes (same problem as above).

“Use ISOs,” you say. ISOs have a similar problem in that the spread is an AMT adjustment and sometimes the AMT is more than an employee can bear.

Where Congress Comes In

Congress is considering a JOBS Act 2.0.

I think it ought to put on its list fixing this situation.

My Recommendations

  • Repeal Section 409A as it applies to startups; meaning, let companies issue discounted stock options. This will allow companies to more liberally share equity with workers.
  • Repeal the AMT as it applies to incentive stock options. If Congress did this, it would really fix a lot of the problems in this area.
  • Don’t impose tax on non-cash transfers of equity at all. This would be the perfect solution. Stock transfers to employees could be then widely used without difficultly.

Conclusion

Congress has the power to fix the tax law to substantially increase worker welfare. Congress, let’s do this.