A recently passed House bill would permit certain start-up
employees to defer taxes on stock options and restricted stock
units (RSUs). The proposed legislation aims to help emerging
companies attract and retain talent by offering equity compensation
on more attractive terms.
Cash-strapped start-ups often grant an ownership stake to
employees to compensate for below-market wages. This strategy
also aligns incentives by giving employees a share of the
However, current tax law makes such equity compensation less
attractive than it might otherwise be. When employees
exercise their stock options or when RSUs vest, they must pay taxes
on the excess difference between the current fair market value and
the purchase price. Of course, the employee hasn't
actually pocketed any cash. So the income is
"phantom" income, but the tax burden is real.
Public company employees have the option to sell shares on the open
market, but there is typically no market for private company stock.
Employees must choose between paying taxes out of pocket or
foregoing their ownership stake. This Hobson's choice can
dilute the value of equity compensation, making it more difficult
for emerging companies to attract top talent.
The Empowering Employees through Stock Ownership
Act (the "Act") seeks to alleviate this tax burden on
illiquid income. Qualified employees working at eligible
companies could defer paying taxes on income from qualified stock
for up to 7 years. Let's unpack those terms:
Qualified Employee: To take
advantage of the tax deferral, employees must be "qualified
employees". This includes all employees except certain
owners and officers: owners of 1-percent or more of the
company, certain executives (CEO, COO or individuals acting in such
capacity), and the company's four highest earning officers are
Eligible Companies: The Act is
intended to incentivize broad-based employee ownership. If a
company wants its employees to qualify, it must have a written plan
under which at least 80% of all U.S. employees who provide services
to the company are granted stock options or RSUs on an annual
basis. The company must also offer stock options or RSUs to
employees on similar terms. Finally, the company cannot be
traded on an established market.
Qualified Stock: Qualified
stock includes stock received in connection with the exercise of a
stock option or vesting of a RSU. The stock must be received
as compensation for services performed as an employee of the
company. Importantly, stock is not qualified if the employee
has the right to sell the stock to the company at the time of
exercise or vesting or to otherwise receive cash in lieu of the
7-Year Deferral: Employees are
currently required to pay taxes in the year in which they exercise
stock options or their RSUs vest. Under the Act, employees
would not have to recognize (or pay taxes on) this income until 7
years after exercise or vesting. Certain triggering events
could cause employees to have to pay taxes prior to the 7-year
anniversary: if the stock becomes transferable (including to
the employer), if the employee becomes an excluded employee, if the
stock becomes tradeable on an established market, or if the
employee revokes the election.
Despite some controversy over how this tax deferral will be
paid for, the Act is generally receiving praise as a move to
strengthen the economy and create jobs by helping early stage
companies attract the talent that will help them succeed.
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