editione2.1.1
Updated September 12, 2022Equity and taxes interact in complicated ways, and the tax consequences for an employee receiving restricted stock, stock options, or RSUs are dramatically different. This section will cover these messy details and help you make decisions that reduce the tax burden of your equity compensation.
This section covers one of the most important and complex decisions you may need to make regarding stock awards and stock options: paying taxes early with an 83(b) election.
Generally, restricted stock is taxed as ordinary income when it vests.
If the stock is in a startup with low value, this may not result in high tax. If itβs been years since the stock was first granted and the company is now worth a lot, the taxes owed could be quite significant.
βDefinitionβ The Internal Revenue Code, in Section 83(b), offers taxpayers receiving equity in exchange for work the option to pay taxes on their options before they vest. If qualified, a person can tell the IRS they prefer this alternative in a process called an 83(b) election. Paying taxes early with an 83(b) election can potentially reduce taxes significantly. If the shares go up in value, the taxes owed at vesting might be far greater than the taxes owed at the time of receipt.
βconfusionβ Why is it called an election? Because you are electing (choosing) to pay taxes early in exchange for this treatment by the IRS. Does the IRS secretly enjoy making simple concepts sound confusing? Weβre not sure.
An 83(b) election isnβt guaranteed to reduce your taxes, however. For example, the value of the stock may not increase. And if you leave the company before you vest, you donβt get back the taxes youβve already paid.
βdangerβ You must file the 83(b) election yourself with the IRS within 30 days of the grant or exercise, or the opportunity is irrevocably lost.
βconfusionβ Note an 83(b) election is made on receipt of actual shares of stock. Technically, it cannot be made on the receipt of a stock option itself: You first must exercise that option, then file the election.
If you receive an early exercisable stock option (when you donβt have to wait for the the stock to vest), you can make an 83(b) election upon receipt of the exercised shares.
Section 83(b) elections do not apply to vested shares; the election only applies to stock that is not yet vested. Thus, if you receive options that are not early exercisable (meaning you have to wait until they vest to exercise), an 83(b) election would not apply.
βimportantβ Founders and very early employees will almost always want to do an 83(b) election upon the receipt of unvested shares, since the stock value is probably low. If the value is really low, and the taxes owed are not that great, you can make the election without having to pay much tax and start your capital gains holding period on the shares.
βnewβ With the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, Congress approved a new Section 83(i) that is intended to allow deferral of tax until RSU and stock option holders can sell shares to pay the tax bill. Whether companies will choose or be able to make this available to employees is not clear yet.
When a personβs stock vests, or they exercise an option, the IRS determines the tax that person owes. But if no one is buying and selling stock, as is the case in most startups, then the value of the stockβand thus any tax owed on itβis not obvious.
βDefinitionβ The fair market value (FMV) of any good or property refers to a price upon which the buyer and seller have agreed, when both parties are willing, knowledgeable, and not under direct pressure to carry out the exchange. The fair market value of a companyβs stock refers to the price at which a company will issue stock to its employees, and is used by the IRS to calculate how much tax an employee owes on any equity compensation they receive. The FMV of a companyβs stock is determined by the companyβs most recent 409A valuation.
βDefinitionβ A 409A valuation is an assessment private companies are required by the IRS to conduct regarding the value of any equity the company issues or offers to employees. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS wonβt consider it reasonable. In order to minimize the risk that a 409A valuation is manipulated to the benefit of the company, companies hire independent firms to perform 409A valuations, typically annually or after events like fundraising.
The 409A valuation of employee equity is usually much less than what investors pay for preferred stock; often, it might be only a third or less of the preferred stock price.
βcontroversyβ Although the 409A process is required and completely standard for startups, the practice is a strange mix of formality and complete guesswork. It has been called βquite preciseβremarkably inaccurate,β by venture capitalist Bill Gurley. You can read more about its nuances and controversies.
A 409A does have to happen every 12 months to grant the company safe harbor. A 409A also has to be done after any event that could be deemed a βmaterial event,β which is a fancy way of saying any event that could change the price or value of the company meaningfully. Other examples could be if a CEO leaves, if the company starts making a ton of money, or if there is an acquisition.
βtechnicalβ βFMVβ is a legal term defined in Supreme Court Case 546, United States vs. Cartwright.
βtechnicalβ β409Aβ is a reference to the section of the Internal Revenue Code that sets requirements for options to be tax-free on grant.
Typically, early to mid-stage companies grant stock options, which may be ISOs or NSOs.
βdangerβWhen you get stock options and are considering if and when to exercise, you need to think about the taxes and when you owe them. In principle, you need to think about taxes you may incur at three points in time:
at time of grant
at time of exercise
at time of sale
These events trigger ordinary tax (high), long-term capital gains (lower), or AMT (possibly high) taxes in different ways for NSOs and ISOs.
βDefinitionβ The taxes at time of exercise will depend on the gain between the strike price and the FMV, known as the spread or the bargain element.
βimportantβ If youβre granted ISOs or NSOs at a low strike price, and the bargain element is zero, then you may be able to exercise at a reasonable price without triggering taxes at all. So assuming the company allows it, it makes sense to early exercise immediately (buying most or all of the shares, even though theyβre not vested yet) and simultaneously file an 83(b) election.
βcautionβ An 83(b) election, as already discussed, is the choice to be taxed on the receipt of property even though you might have to forfeit or give back the property to the company. You can make an election on the receipt of stock, but you cannot make the election on the receipt of a stock option or an RSU because options and RSUs are not considered property for the purposes of Section 83(b).
βcautionβ ISOs are often preferred by startups, as theyβre supposedly better for employees from a tax perspective. This assumes that (1) AMT wonβt be triggered and (2) youβll get a low long-term capital gains rate by holding the stock for the appropriate holding periods. However, often you either run afoul of the AMT trap, or donβt hold the stock long enough with the complicated 1 year + 2 year requirement, or the spread at exercise is small or zero, so the difference wouldnβt matter anyway. NSOs do have a slightly higher tax because of the need to pay employment taxes on NSOs and not ISOs.
βcontroversyβ Overall, itβs not clear the ISO is that much better for employees, so many people argue for NSOs instead.
βconfusionβ This is partly because ISOs can make it harder to meet the long-term capital gains holding period.* Many people expect early exercise, together with an 83(b) election, will help them hold the stock long enough to qualify for long-term capital gains. While this is true for NSOs, a murky part of the rules on ISOs states that even with an 83(b) election, the capital gains holding period does not begin until the shares actually vest. So if you want to immediately exercise an option and file a Section 83(b) election, and you might have liquidity soon, itβs betterβfor those who canβto do so with NSOs.
When it comes to taxes and equity compensation, one scenario is so dangerous we give it its own section.
βdangerβ If you have received an ISO, exercising it may unexpectedly trigger a big AMT billβeven before you actually make any money on a sale! If there is a large spread between the strike price and the 409A valuation, you are potentially on the hook for an enormous tax bill, even if you canβt sell the stock. This has pushed people into bankruptcy. It also caused Congress to grant a one-time forgiveness, the odds of which happening again are very low.
βDefinitionβ The catastrophic scenario where exercising ISOs triggers a large AMT bill, with no ability to sell the stock to pay taxes, is sometimes called the AMT trap. This infamous problem has trapped many employees and bankrupted people during past dot-com busts. Now more people know about it, but itβs still a significant obstacle to plan around.
βnewβ In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), which increases AMT exemptions and their phaseout thresholds. This means fewer people will be affected by AMT in 2018 and later than in prior years.*
Note that if your AMT applies to events prior to 2008, youβre off the hook.
Understand this topic and talk to a professional if you exercise ISOs. The AMT trap does not apply to NSOs.
Because the differences are so nuanced, what follows is a summary of the taxes on restricted stock awards, ISOs, and NSOs, from an employeeβs point of view.
Restricted stock awards. Assuming vesting, you pay full taxes early with the 83(b) or at vesting:
At grant:
if 83(b) election filed, ordinary tax on FMV
none otherwise
At vesting:
none if 83(b) election filed
ordinary tax on FMV of vested portion otherwise
At sale:
long-term capital gains tax on gain if held for 1 year past when taken into income
ordinary tax otherwise (including immediate sale)
NSOs. You pay full taxes at exercise, and the sale is like any investment gain:
At grant and vesting:
At exercise:
ordinary income tax on the amount by which the FMV of the shares received exceeds the exercise price
income and employment tax withholding on paycheck
At sale:
long-term capital gains tax on gain if held for 1 year past exercise
short-term capital gains tax (ordinary income tax rates) otherwise (this includes immediate sale at exercise)
ISOs. You might pay less tax at exercise, but itβs complicated:
At grant and vesting:
At exercise:
AMT tax event on the bargain element
no ordinary or capital gains tax
no income or employment tax withholding on paycheck
At sale:
long-term capital gains tax if held for 1 year past exercise and 2 years past grant date
short-term capital gains tax (ordinary income tax rates) otherwise (this includes immediate sale at exercise)
Mary Russell, a lawyer who specializes in equity compensation, recommends each form of equity be used at the appropriate time in private companies: restricted stock awards for the earliest stage of a startup, stock options with longer exercise windows for the early to mid stage, and RSUs for the later stages.*
If you relish tax complexity, you can learn more from:
The Tax Topics coverage of ISOs and NSOs from the IRS
Joe Wallinβs posts on the Startup Law Blog, βTop 6 Reasons To Grant NQOs Over ISOsβ and βIncentive Stock Options vs. Nonqualified Stock Optionsβ
Investopediaβs post βGet the Most Out of Employee Stock Optionsβ
EquityZenβs summary of the topic, βUnderstanding Equity Compensation And What It Means For Startup Employeesβ
If you are awarded RSUs, each unit represents one share of stock that you will be given when the units vest.
Hereβs the tax summary for RSUs:
At grant:
At vesting/delivery:
At sale:
long-term capital gains tax on gain if held for 1 year past vesting
short-term capital gains tax (ordinary income tax rates) otherwise (this includes immediate sale)
If you receive an RSU when the stock is of little value, you cannot elect to be taxed on the value of that stock when you receive the RSUβyou pay taxes at vesting time, based on the value of the shares at that time.
βcautionβ RSUs present some big problems in private companies:
You will owe tax when you receive the shares, even though they are illiquid.
You canβt minimize the tax impact of an increase in value of the underlying shares between the date you receive the RSU and the date it is settled.
If you are an employee you will have to write a check to the company to satisfy your income and employment tax withholding.
βcautionβ RSUs are less attractive than stock options from a tax point of view because you cannot make an 83(b) election with respect to RSUs. By contrast, if you receive a stock option, as long as itβs priced at fair market value you will have no income upon receipt of the options, and your income tax and employment tax consequences will be deferred until you exercise, an event under your control for the most part.
This table is a summary of the differences in taxation on types of equity compensation.
| Restricted stock awards | ISOs | NSOs | RSUs | |
|---|---|---|---|---|
| Tax at grant | If 83(b) election filed, ordinary tax on FMV. None otherwise. | No tax if granted at FMV. | No tax if granted at FMV. | No tax. |
| Tax at vesting | None if 83(b) election filed. Ordinary tax on FMV of vested portion otherwise. | No tax if granted at FMV. | No tax if granted at FMV. | Ordinary tax on current share value. |
| Tax at exercise | AMT tax event on the bargain element. No ordinary or capital gains or employment tax. | Ordinary tax on the bargain element. Income and employment tax. | ||
| Tax at sale | Long-term capital gains tax on gain if held for 1 year past when taken into income. Ordinary tax otherwise (including immediate sale). | Long-term capital gains if held for 1 year past exercise and 2 years past grant date. Ordinary tax otherwise (including immediate sale). | Long-term capital gains if held for 1 year past exercise. Ordinary tax otherwise (including immediate sale). | Long-term capital gains tax on gain if held for 1 year past vesting. Ordinary tax otherwise (including immediate sale). |
Because they are so important, we list some costly errors to watch out for when it comes to taxes on equity compensation:
βdangerβ If you are going to file an 83(b) election, it must be within 30 days of stock grant or option exercise. Often, law firms will take a while to send you papers, so you might only have a week or two. If you miss this window, it could potentially have giant tax consequences, and is essentially an irrevocable mistakeβitβs one deadline the IRS wonβt extend. When you file, get documentation from the post office as well as a delivery confirmation, and include a self-addressed, stamped envelope for the IRS to send you a return receipt. (Some people are so concerned about this they even ask a friend to go with them to the post office as a witness!)
βdangerβ Watch out for the AMT trap weβve already discussed.
βdangerβ If you exercise your options, and your income had been from consulting rather than employment (1099, not W-2), you will be subject to the self-employment tax, which consist of both the employer and the employee side of FICA. In addition to owing the normal income tax, this means you will owe the Social Security tax component (6.2%) up to the FICA wage base, and you will owe the Hospital Insurance component (2.9%) on all of your income.
βdangerβ Thoughtfully decide when to exercise options. As discussed, if you wait until the company is doing really well, or when you are leaving, the delay can have serious downsides.
Once you understand the types of equity and their tax implications, you have many of the tools you need to evaluate an offer that includes equity compensation, or to evaluate equity you currently have in a company.
In summary, you have to determine or make educated guesses about several things: