Employees generally must recognize income upon the receipt of employer stock to the extent that the fair market value of the stock received is greater than the amount, if any, paid by the employee for the stock. If the employee is taxed on receipt of the stock, that could be a real problem, as he or she may not have the cash on hand to pay the income tax due if the stock is not readily tradeable on an established market. The problem is particularly acute when the valuation of the stock has increased dramatically between the option grant date and the exercise date. The result very often is that employees simply allow their options to expire and thus forfeit a major component of their compensation and the upside potential it represents.
Last year, the U.S. House of Representatives passed the Empowering Employees Through Stock Ownership Act (the “Bill”). The Bill never received a vote in the Senate. The Bill sought to alleviate the income tax burden of employees of non-publicly traded companies who exercise options or receive stock in settlement of restricted stock units (“RSUs”). Companies, particularly start-up companies, often prefer to compensate their employees with equity awards (such as options or RSUs) in order to conserve cash and attract, retain and incentivize employees by providing them with a stake in the success of the venture.
The Bill would permit certain “qualified employees” to elect to defer, for income tax purposes, the inclusion in income of the amount of income attributable to a qualified employee’s receipt of “qualified stock” from an “eligible corporation.”
Qualified employees would generally include any employee who has not previously been a one percent stockholder, CEO, CFO, a family member of any of the foregoing or a highly compensated officer.
Qualified stock would be any stock of a corporation if (1) an employee receives the stock in connection with the exercise of an option or in settlement of an RSU, and (2) the option or RSU was provided by the corporation to the employee in connection with the performance of services and in a year in which the corporation was an “eligible corporation” (as described below). However, qualified stock does not include stock if an employee may, at the time the employee’s right to the stock becomes substantially vested, sell the stock to, or otherwise receive cash in lieu of stock from, the corporation.
A corporation is deemed eligible with respect to a calendar year if (1) no stock of the corporation is readily tradable on an established securities market during the calendar year or any preceding calendar year, and (2) the corporation has a written plan under which, for the calendar year, not less than 80% of the corporation’s employees are permitted to receive stock options or RSUs with the same rights and privileges to receive qualified stock. In applying the requirement that 80% of employees receive stock options or RSUs, excluded employees and part-time employees are not taken into account. Employees would not fail to be treated as having the same rights and privileges to receive qualified stock solely because the number of shares available to all employees is not equal in amount.
If an employee were to elect to defer income inclusion, the deferral would end and the income would be included for the taxable year that includes the earliest of (1) the date the qualified stock is sold, exchanged or otherwise disposed of; (2) the date the employee first becomes an excluded employee; (3) the first date on which any stock of the employer becomes readily tradable on an established securities market; (4) seven years after the employee’s right to the stock becomes substantially vested; and (5) the date the employee elects to include the amount in income. The amount included in income is the same amount that, but for the election, would have been included in income for the taxable year in which the employee’s right to the stock became substantially vested.
The Bill appears to be a step in the right direction to remedy the issue of illiquid option exercise and/or stock settled RSUs. However, the deferral does not apply to employment taxes or state and local taxes, which can result in a substantial tax payment despite the federal income tax deferral (as much as 20% for a New York City resident). In addition, the deferral period is limited to seven years, which may not be a long enough period to induce employees of certain small pre-IPO companies to exercise their options. Finally, it is not clear how impactful the Bill would really be given the trend toward phantom equity arrangements. It will be interesting to see how this issue may be incorporated into the tax reform proposals being crafted in the new Congress.