Deep Dives

Taxation of Employer Equity

This article is a continuation of Understanding Employer Equity. If you haven’t already, head there first to get a handle on the different types of equity and which apply to you. Ok, jumping right in!

July 21, 2022

This article is a continuation of Understanding Employer Equity. If you haven’t already, head there first to get a handle on the different types of equity and which apply to you. Ok, jumping right in!

How are ISO options taxed?

Say you exercise your options for $2 when the equity is worth $10, and then later sell when the equity is worth $15. When you exercise, you may owe alternative minimum tax (AMT) on the $8 per share gain ($10 value minus $2 you paid) when you file your taxes at the end of the year. When you sell your shares, you will pay taxes on the whole gain of $13 ($15 selling price minus $2 you paid). Since you’ve already paid AMT on the shares, you can get those AMT payments back as credits (though it may take a few years to get it all back). 

The tax rates depend on a few factors, but for the best tax outcome, we recommend exercising and holding the equity for at least 1 year before you sell. The other trigger is to ensure that at the time of sale you are at least 2 years from the original equity grant (typically your first day at work). This is shown as “Scenario 5” below. Failing to hold the equity for at least 1 year (Scenarios 1, 2, and 3) will mean paying ordinary income tax rates on gains, which is higher than capital gains tax. Selling within 2 years of of the original grant is “Scenario 4.” Where possible, “Scenario 5” is ideal. 

 

What is an 83(B) election?

As stated above, when you exercise options, you will owe AMT on the bargain element if you don’t sell the shares in the same year. If the bargain element was 0 (strike price = fair market value), you wouldn’t owe any AMT. When you first get your options the bargain element is 0. However, in most cases, you can’t exercise during the first year because your shares haven’t vested and the fair market value could rise, causing the bargain element to rise above zero and triggering AMT.

If your company allows you to exercise unvested shares, you can file an 83(b) election within 30 days of early exercise. You’ll have to pay the strike price to your company, but you won’t owe any taxes or AMT. If you hold the shares for 1 year (or 2 years after the grant) before selling, you’ll only owe long-term capital gains on the gain (amount above the strike price). This could be a good way to avoid paying AMT upon exercise. If you leave your employer before some options vest, your employer will buy them back at the strike price. The decision to do an 83(b) election centers around tax benefits and how much money you want to risk immediately to buy your company’s shares.

How are NSO options taxed?

For NSOs, when you exercise, you have to pay ordinary income tax on the spread between the strike price and the FMV (the bargain element). This amount is due immediately when you exercise; you don’t get to wait until the following April to pay it. Although you haven’t actually sold the equity, you still have to pay income tax on the unrealized gains. When you do sell the equity, you will report the capital gains (or losses), which is the difference between the selling price and the FMV when you exercised.

How are RSAs taxed?

When you purchase the RSAs, there are no taxes. As RSAs vest, you’ll have to pay ordinary income tax on any gain between the purchase price and the FMV at vesting. When you sell RSAs, you’ll pay capital gains tax on any additional gains between the FMV at vesting and the sale price. Income tax is typically higher than capital gains tax, and it may be challenging to pay income taxes because the shares may not be easily sold to pay for the taxes. This means you will need to come out of pocket to pay the taxes. 

An 83(b) election lets you pay for your income tax immediately instead of waiting for vesting. This can be beneficial because there might be zero income tax if you purchased the shares for the current FMV, or it might be really small if you purchased them at a discount or received them for free. Remember, you pay tax on the difference between the purchase price and the FMV when you buy it. When you sell your shares, you’ll pay capital gains taxes on all the gains above what you paid for them at the grant. This is significantly better than the previous scenario, so if possible, use an 83(b) election.

How are RSUs taxed?

When RSUs vest, you pay ordinary income tax on their full value. There’s no 83(b) election with RSUs. When you sell, you’ll pay capital gains taxes on any increase in share price. RSUs can quickly un-diversify your overall asset allocation because you may have a large percentage of your liquid net worth in one company stock. We recommend trying to keep concentrated positions to 10% or less of your overall portfolio, so it might make sense to sell your RSUs immediately after they vest to minimize your capital gains tax. 

While it’s most common to receive RSUs when your company is already publicly traded, there is a possibility that RSUs are granted pre-initial public offering (IPO). If this occurs, there may be what’s called a “double-trigger,” which requires both the RSUs to be vested and a liquidity event. The liquidity event could be: (1) the company goes public; (2) it is acquired or merged; or (3) it is sold in a private equity market. The rationale for this is if the shares are taxed as income when received but you can’t sell them to pay the tax, this could create challenges. Therefore, most companies will not have you taxed on the RSUs until both events happen: vesting and a liquidity event.

As you can see, the taxation of employer equity can be complex. We recommend you consult a tax specialist for the most tax efficient route when considering exercising and/or selling your employer equity.

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