Many startup employees receive stock options from their employers as an incentive for helping the company launch and achieve success. Stock options allow employees to buy shares of their company’s stock at a fixed price — called the strike price. When employees exercise this option to buy, they pay the strike price regardless of the shares’ actual market value at the time.
If you’re lucky enough to work for a startup company that progresses through an exit event such as an IPO or acquisition, you can further capitalize on this option by instantly cashing in on the difference between your strike price and the actual price paid by a buyer. Your windfall will be subject to income tax, of course, because you made a tangible profit when you sold the stock for more than you paid to buy it.
But what if your company isn’t ready to go public or merge with another organization? You still can buy shares at the strike price. What’s the benefit? You might choose this route because you’re leaving the company or want to take advantage of long-term capital gains tax benefits, should the shares become saleable in the future.
IRS currently assesses taxes on unsaleable shares.
Even though shares of stock in private companies can’t be sold on the open market, they still have a fair market value, based on Section 409A of the Internal Revenue Code. If the fair market value is higher than your strike price, current IRS rules will make you think twice before buying your hard-earned shares early. That’s because you’ll owe taxes on the difference between the fair market value of the unsaleable stock and the strike price you paid for those shares — despite not being able to sell the shares. Even worse, if your company never has an exit or goes out of business, you can’t recoup taxes paid to the IRS.
House bill would give startup employees more options for their options.
Those rules might be about to change. The Empowering Employees Through Stock Ownership Act, HR 5719, passed by a vote of 287 to 124 on Sept. 26, 2016, and advanced to the Senate. It seeks to amend the Internal Revenue Code by allowing startup employees to defer the inclusion of income from their stock options until one of three events takes place:
- The employee becomes an excluded employee,
- The company’s stock becomes readily tradable on an established securities market, or
- Seven years have passed after the rights of the employee in the stock are transferrable or are not subject to a substantial risk of forfeiture.
Employees also reserve the right to include the amount in their income and pay taxes at the time they exercise their stock options — just as they do now, under existing rules.
Certain requirements apply in order for the employee to qualify for a deferral, and companies and employees alike always should seek professional tax and legal advice before acting. Here’s one of several important provisions: The company must have a written plan that states at least 80 percent of all employees have the same rights and privileges to receive stock.
The proposed bill now must pass the Senate, but its existence is a welcome sign that Congress is looking out for startup employees who take risks in the name of entrepreneurism. Track the bill’s progress at Congress.gov and monitor action on related bills there as well.