Equity compensation is an amazing way to reward employees and facilitate an organization’s growth by encouraging sentiments of employee ownership and accountability. However, many entrepreneurs and equity holders are not aware of the tax implications, especially for stock options and restricted stock awards. If this statement resonates with you, then it is high time that you brush up on your knowledge about startup equity taxes. 

What is Startup Equity?

Before delving into the tax implications of startup equity, it is essential to know what equity is all about. Simply put, startup equity is a non-cash compensation that represents partial ownership of a company. When a startup issues equity, it can access the required capital, garner support from investors, and establish a robust foundation for future growth and success. Startup equity can be distributed among founders, investors, advisors, and employees in exchange for services or seed money. Furthermore, you must also be aware that not all startup equity is alike. There are several types of equity, such as stock options, common shares, preferred stock, etc. These variations have a direct influence on the tax implication. 

• Common Shares

The initial investment of a person in a startup is known as common shares or common stock. Usually, up-and-coming entrepreneurs offer venture capitalists common shares or stock along with the right to a specific portion of the startup’s assets.

• Stock Options

They are a way to grant equity to employees while the company is still growing and prospering. With stock options, employees have the choice to purchase company stocks at a predetermined price based on the market value. So, if a worker buys stocks, they can reap the benefits of the company’s growth in due course of time, after their holding requirements are met.

• Preferred Stock

Lastly, preferred stocks are another type of equity that startups can issue. They provide stakeholders a stake in the company without the voting rights enjoyed by common stock stakeholders. 

Now that we know about the basics of startup equity, let us analyze its tax implications.

Startup Equity and Tax Implications - What Does It Mean for Employees and the Company?

Under usual circumstances, three types of taxes may be applicable for startup equity. These include - ordinary income tax, capital gains tax, and payroll tax. To begin with, income tax, which is the most common type of tax, is applicable to both vested and unvested stock options. 

On the other hand, capital gains tax only applies to stock options based on the difference between the strike price and the stock’s current market valuation. However, capital gains tax ought to be paid only if the startup venture is successful and the investment sells their startup shares for a price higher than they paid for them. This is because the IRS levies tax on any gains or profit earned from the sale of assets.

Contrarily, if the startup venture does not perform well and the capital loss is incurred, the consequent losses can offset capital gains. So, if there are no capital gains left to offset, these losses may be deemed loss carry-forwards, and they can offset taxable income up to USD 3000 per year. 

Lastly, the payroll tax is a deduction from the employee's paycheck and is relevant for restricted stock units (RSU) that have been granted to the workforce of a startup. The proportion of payroll tax due depends on the employee’s marginal tax rate.

Tax Treatments for Common Startup Equity Types

• Stock Options

Stock options are usually divided into two parts - Incentive Stock Option (ISO) and Non-Qualified Stock Options (NQSOs). When an employee exercises or buys their stock options, they usually do not owe any taxes on them. However, they must include the exercise price and the FMV  difference at exercise in their alternative minimum tax (AMT) calculation for the concerned year. But, it is essential to note that when an employee sells their shares, they are liable to additional taxes.

• Employee Stock Purchase Plans (ESPPs)

They are a discretionary benefit that enables employees to buy company stock at a heavily discounted price using after-tax payroll deductions. The time an employee waits before selling their shares is crucial and so is the value of their shares during the bidding process. If the stock is sold a year after purchase or two years after the beginning of the offering period, a portion of the gain over the purchase may be treated as a long-term capital gain. And, long-term capital gains are usually taxed at a lower rate compared to short-term capital gains. The latter is applicable when an employee sells their share within one year of holding them.

• Restricted Stock Units (RSUs)

RSUs are a promise made by a startup to deliver shares to their employees once their RSUs have been vested. So, you owe the usual income tax on FMV of the shares delivered to you when the RSUs are vested, and your company is most likely to withhold applicable taxes at vest/delivery. However, you may be subject to extra tax implications when you sell the shares.

Taxation of Equity Compensation - Common Mistakes that Companies Should Avoid

After a crisp overview of the tax treatments of common startup equity types, let us wrap up the article by checking out the common mistakes that organizations usually make and that you must avoid.

The first and the most obvious mistake that employees make vis-a-vis taxation of equity is not having a firm grasp on the tax consequences of receiving company stock. Employees receiving stock from their employees may be subject to different types of tax, and failure to recognize and pay can have repercussions, such as legal notice by the IRS, fines, fees, and more. 

Likewise, the enterprise giving out stock to its employees must be aware of the vesting schedule and report the income on the employees’ tax returns in the year they vest. Thus, it is essential for private companies to fully grasp the tax liabilities that come with equity compensation, before offering it to employees. A failure to do so can attract penalties and hefty charges. Thereafter, to streamline everything, a startup equity calculator can help. 

Conclusion

So, there we have it, a crisp overview of the tax implications of startup equity.