I did a little research on this and I am still not sure I get it. If a start up compensates key personel with stock options or RSU s that have a vesting period of one year they owe no tax for that year on the options. At one year plus a day the options vest and a tax liability is incurred. However, because they have vested the holder can exercise thier options or a portion of (thier choice) and pay thier tax liability with the proceeds. Am I missing something here?
A proposed tax that charges people as their startup equity vests instead of when they cash it out and actually have money to pay the taxes could wreck how tech companies recruit talent. And the industry doesn’t have much time to mobilize to get this tax changed.
The U.S. Senate released its proposed tax reform bill late last week under the aggrandized “Tax Cuts and Jobs Act.” It includes a tax on stock options and Restricted Stock Units (RSUs) that applies as they vest, rather than using the existing scheme that taxes stock options when they’re exercised or when the underlying shares are released for RSUs.
As famed VC Fred Wilson of Union Square Ventures explains, “What this would mean is every month, when your equity compensation vests a little bit, you will owe taxes on it even though you can’t do anything with that equity compensation. You can’t spend it, you can’t save it, you can’t invest it. Because you don’t have it yet.”
That’s a huge problem. Because if you’re not already quite wealthy, you might not be able to afford to pay those taxes until you actually liquidate your equity for cash. The proposed tax could prevent wide swaths of tech employees from accepting stock options and RSUs. This breaks the whole incentive structure for top talent to take intense jobs at companies with a risk for failure because there’d no longer be the potential for massive upside.
If there’s no shot at getting rich for grinding it out as an early employee at a startup, top talent won’t take those jobs.
UNITED STATES – OCTOBER 04: Amanda Werner, who is dressed as Monopoly’s Rich Uncle Pennybags, sits behind Richard Smith, left, CEO of Equifax, during a Senate Banking, Housing and Urban Affairs Committee hearing in Dirksen on the company’s security breach on October 4, 2017. (Photo By Tom Williams/CQ Roll Call)
Companies would have to shift to higher salaries and big bonuses to attract the best employees. But startups often don’t have the cash to do that. In order to attract talent they rely on equity that’s free to dole out at the time and only worth a lot if the company succeeds. This could push top product, design, engineering and sales people to work at bigger, established companies that can afford juicy salaries and bonuses. And with fewer equity-made millionaires and billionaires, there will be fewer people investing in the next generation of startups.
This in turn could reduce innovation, prevent the disruption of aging giants and lower the U.S. tech sector’s competitiveness with the world.
There’s no doubt that the tech industry is frothy, tons of people are accumulating huge wealth via equity and they could probably afford to pay higher taxes. But that’s only after they’ve earned their fortune by liquidating equity. A tax on vesting dissuades people from ever taking a swing for the fences.
[Update: One policy option would be to follow Canada’s lead, where vesting is taxed but smaller private corporations like startups get an exemption. Otherwise, if the law goes into place, startups might have to adopt profit sharing models to attract talent. But that would only help certain fast-to-profit startups, not the build/grow now and monetize later startups that often become the biggest.]
Wilson recommends that people who want to fight this should call their senator, speak with the aide covering tax reform and ask for this tax on vesting to be changed or removed from the Tax Cuts And Jobs Act. The Senate could potentially try to push the Act through before year’s end. And if the vesting tax becomes law, it could wreak havoc on the startup world.
Senate plans disastrous tax on vesting that could kill stock compensation
- Thread starter ajacobson
- Start date
in a private company you can't always sell your options or even stock grants. Vesting in this case only means that if you leave, you still own it. What's interesting is that they are adding this tax but working to drastically reduce death taxes on illiquid assets you bequeath your children.
Ok but wether you can or can not exercise/sell your options is covered by how your employment and articles of incorporation are written. I know of no law that would require stake holders to not sell thier stock after vesting. With the possible exception of startup that raised capital pursuant to title III of the JOBS Act. Do you?
think about it practically. You work for a startup and have a million dollars of newly vested stock. You make 100k in salary. What mechanism do you have to liquidate 25percent of your non-tradable pre-iPo stock to pay your tax bill.
Good example. Subject to advice from my attorney my quick answer would be this. In writting make the vesting schedule contingent on the company issuing its IPO or alternatively, restructure the compensation (formerly options/RSU s) as convertible debt that becomes equity upon IPO issuance. The latter would be my preference since if the company goes under the unpaid note would yield some degree of tax benifit to the employee.
I would assume a convertible debtenture would be taxable as well.
To Sig's point, the whole point of working at a startup (read: a new business venture that is creating innovation and employment) is for the equity. Often you have to give up cash compensation (as the only currency these companies have is their equity). This disincentivizes people to work for startups.
What happens if your stock vests and then the company goes under in my example? 250k of capital losses at 3k a year!
Yes your right. And that equity sooner or later converts to income. Whether its options, stock or convertible debt its all the same. Just write the compensation package so that it does not vest until its sellable. Whether you pay taxes on the day it vests or 10 years later does not matter. I hate it too brother but we make money we pay taxes.
You are entirely missing the point. It matters a whole hell of a lot if I have to pay taxes on options the day they vest when I'm making $50,000 a year living in San Francisco and there's a non-zero probability that I'll never even exercise the options because the company won't be in business in 5 years, vice paying those taxes when the company IPOs and the I exercise the options into stock I can easily sell for far more than I owe in taxes. Startups don't think about taxes at all except the taxes they have to pay when they're in startup phase and every dollar counts as the difference between success and failure. This bill moves taxes from the realm of "wish I didn't have to pay so much of my windfall in taxes" to "can't do this job because I can't afford taxes on money I haven't made yet". Huge Huge difference in how people make decisions and outcomes for entire industries.
As for waiting for options to vest until they're sellable. First, read section 409A of the tax code. Generally deferred compensation is not only taxable but has an extra 20% tax penalty attached, and what you're proposing would clearly fall under 409A.
Second, I'm not sure you get the point of vesting. It's the primary mechanism in the startup world to reward longevity of effort from employees. You give an employee a decent set of options, and put them on a 3 year vesting schedule so the longer they stay the more of the options they get. Any options that vest are theirs to keep, even if they leave before 3 years. Your idea eliminates both the central tenants of vesting, so again why blow up what's worked so well for....wait a minute why are we doing this again? Because jobs?
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We're talking about a 10 person startup pre-revenue with maybe an angel investor. There in fact is a law called the Securities Act of 1933 that says you can't sell unregistered stock to anyone who isn't a qualified investor, so that eliminates more than 99% of your potential buyers. Now you've got shares worth 1% of a company notionally worth $1M, where exactly are you going to find the qualified investor to buy your notionally $10,000 worth of stock? Just a hint from someone who's been there....not happening!
Just because there isn't a law against something, doesn't mean it's in any way feasible, by the way. As far as I know there's no law against traveling to Uranus either, but it's not common to expect people to do so just because "there isn't a law against it".