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.IRS 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”).  Empowering Employees Through Stock Ownership ActCompanies, 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

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

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

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.

Eligible 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.

Deferral

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.

Analysis

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.

Of the countless details and decisions that the founder of a startup company is inevitably juggling as he launches his startup, one of the most important is making a timely Section 83(b) election.  Under Section 83 of the Internal Revenue Code, an employee is not taxed on restricted stock received from an employer as compensation until the employee’s rights in the stock are either “transferable” or  “not subject to a substantial risk of forfeiture”—that is, until the stock vests.  While the advantage of this arrangement is that the employee does not have to report income at the time that he or she receives stock, the downside is that he has to report the full value of the stock (less any amount paid for it by the employee) as ordinary income at the time it vests.  In the case of a successful startup, this value will likely have increased substantially from when the stock was initially received.

The solution to this problem is to make an election under Section 83(b).  Under that provision, the recipient of the stock can elect to accelerate the taxable event by including in his or her taxable income the amount realized in the year in which he or she receives the stock.  This amount is equal to the excess of the fair market value of the stock at the time of the initial transfer over the amount paid for the stock by the employee, a number that typically nets out at or close to zero.  If the 83(b) election is made and income is recognized at the time of transfer, the compensation element of the transaction closes and the taxpayer is thereafter treated as the owner of the stock for tax purposes.  Thus, in addition to saving the taxpayer from having to pay ordinary income tax on the appreciation of the stock’s value, any gain on a subsequent sale of the stock will be treated as capital gain provided that the employee has held the stock for at least twelve months.

One thing for investors to keep in mind is that if you snooze, you lose: an election under Section 83(b) must be made within thirty (30) days of receiving employer stock, and there are no exceptions for meeting this deadline.  Thus, it is critical that a taxpayer considering a Section 83(b) election move promptly.  Considerations for the employee of a startup with respect to this election might be how much tax would be owed if reported immediately, how great the likelihood of forfeiture is, and what sort of growth in the value of the stock can be reasonably projected.

There are other wrinkles and nuances, many of which are dealt with in extensive Treasury Regulations and other administrative guidance promulgated in connection with Section 83, so it is best to seek advice of tax counsel when considering the election.

            The debate over the taxation of “carried interest” has been percolating for years and the release of Mitt Romney’s personal tax returns in connection  with his presidential campaign  generated more wide-spread interest in the subject.  And while the relatively preferential tax rates that fund managers pay on these investment profits survived the “fiscal cliff” budget deal at the beginning of 2013, interest in this topic is as strong as ever.    

What is Carried Interest?

             Carried interest, or “carry” as it is commonly called, is a right that entitles the general partner (“GP”) of a private investment fund to a share of the fund’s profits in exchange for managing the fund’s investments.  The GP, made up of individual investment professionals, contributes a relatively small amount of capital to the fund but takes on the role of managing the fund’s underlying investments.  In return, the GP typically receives an annual management fee equal to 2% of the fund’s assets, and a carry equal to 20% of the fund’s profits in excess of a specified return hurdle.  Because the GP is usually itself a flow-through entity for income tax purposes, the individual investment managers report and pay income tax on these amounts.

What is at stake?

             Under current law, the management fee is taxed like wages, subject to payroll taxes and  potentially higher, ordinary income tax rates.  The carry, on the other hand, is taxed at capital gains rates as an investment profit, subject to lower capital-gains income tax rates.  Currently, the top rate on capital gains is 20%, with an additional 3.8% surtax on investment income of the highest earners, while the highest Federal income tax rate applicable to wages is equal to 39.6%.  Without even taking into account the impact of payroll taxes, a change in the taxation of carried interest from capital gains to ordinary income would result in a 66% increase in federal taxes due with respect to these amounts.

Those in favor, those against

             Critics of the current rates of tax on carry argue that this amount is effectively compensation for services and should, therefore, be taxed like any other wages.   Proponents of taxing carry at lower capital gains rates, however, argue that carry is simply a share of the profit in a long-term investment.  The amount, they say, is at risk and that risk should be rewarded accordingly.

Venture Capitalists may have a better argument than other types of GPs

            Some argue that venture capitalists have an even better argument than their buy-out firm counterparts for lower tax rates on their carry.  The typical buy-out firm invests in established yet struggling companies, or companies that need a capital infusion to break beyond their current level of success.  They seek to sell the improved company at a profit within a relatively short horizon.  Venture capital firms, on the other hand, put their money at risk when a Company is in a much earlier and less mature stage, where it may take years to a generate a profit on that investment.   This, they say, is the true definition of capital gains:   incentivizing the investor to make a risky bet in the hopes of a big payoff down the road.   Critics of reform point out that without this tax incentive, venture capitalists will be less likely to take chances on start-up ventures which, in turn, negatively impacts U.S. business development and the economy as a whole.

Outlook Uncertain   

            President Obama has vowed to continue to take up this issue in budget talks.  As a result, asset managers will need to take potential reform into account when evaluating new investments, incorporating this political variable into their financial models.   While venture capitalists are arguably well-practiced in building some degree of uncertainty into the equation, there is no formula for predicting the outcome of this debate.  Thus, they will be left to judge, as best they can, the wisdom of taking a chance on a start-up venture without knowing exactly what the toll to be paid at the exit ramp will be.