While start-up founders and executives are often excited by an impending exit, liquidity events may affect equity compensation in complex ways. That’s why it’s important to understand how different types of equity grants are taxed, the tax planning strategies available before an initial public offering (IPO) and strategies for selling stock after the IPO. Be aware, state and local taxes may vary.
Taxes for Different Types of Equity Compensation
Employees are often granted different types of equity awards:
- Restricted stock units (RSUs) represent the promise to deliver company shares when either time-based or performance-based vesting requirements are met. Once RSUs are converted to shares, their market value is subject to ordinary income tax. For private companies, however, recipients face restrictions on liquidating their shares. To avoid a potential cash crunch in covering the tax liability, private companies may offer “double trigger” vesting in their plan document or RSU grant agreement that states RSUs will vest only after a liquidity event, such as an IPO. Under federal tax rules, when selling the underlying shares, recipients realize capital gains or losses based on first, the differential between the sales price and the fair market value at the time of vesting and settlement and second, will also receive long-term capital gains or loss treatment if they hold the shares for more than one year.
- Restricted stock awards (RSAs) are grants of company stock subject to vesting requirements that are subject to ordinary income taxes on vesting. However, by making an IRC Section 83(b) election within 30 days of the RSA grant, federal tax rules allow recipients the option to pay ordinary federal income tax upfront based on the value of their shares on the grant date which establishes their cost basis. Sales of shares after vesting are then subject to capital gains taxes for any gain above the cost basis—delivering federal tax savings if the value of the stock rises between the grant date and the vesting date. The downside? If the stock price falls or the holder leaves the company before vesting, they cannot get a refund or credit for the taxes they have already paid.
- Stock options give holders the right to buy shares at a pre-set price (the “strike price” or “exercise price”) and are typically exercised when the company’s stock price exceeds the strike price (meaning the option’s “intrinsic value” is positive). For private companies, that strike price is typically determined by a 409A valuation. The tax treatment depends on the type of stock option exercised. Exercising non-qualified stock options (NQSOs) results in ordinary federal income tax due based on the options’ intrinsic value, while selling the underlying shares results in either short- or long-term capital gains taxes which for federal tax purposes depends on how long recipients hold the shares. Exercising incentive stock options (ISOs) may trigger the federal Alternative Minimum Tax (AMT), depending on the options’ intrinsic value and a recipient’s regular taxable income. Sale of the underlying shares are subject to long-term capital gains tax rates if, as required for federal tax purposes, they’re held for at least one year after exercise and two years after the grant date. If the required holding period is not met, the spread will be taxed as ordinary income.
- Stock appreciation rights (SARs) represent a promise to pay an amount based on the appreciation of company stock over the stated exercise price and may be settled in shares or cash. Like options, the intrinsic value at exercise is considered ordinary income for federal tax purposes.
Pre-Liquidity Tax Planning
To potentially help your executives benefit from the value created from their equity compensation before a liquidity event, consider these two tax planning strategies. Though we recommend seeking legal and tax advice regarding your personal situation before implementing these strategies.
Early exercise: For those with bullish views on their company stock, exercising their options before an IPO or liquidity event can “start the clock” on qualifying future appreciation as long-term capital gains. If the company ultimately goes public at a value higher than the exercise price, holders could save significantly on taxes. That said, early exercise raises several risks. If the company stock falls, investors may be unable to recover the taxes triggered by the exercise (or the upfront money paid to exercise the options). And if the stock’s price falls to zero, they would lose the total value of the stock as opposed to just the option value.
Transfer Tax planning: A way to potentially minimize transfer taxes (federal, and potentially, state, estate, and gift tax) involves gifting pre-IPO shares to a beneficiary (who is not a U.S. citizen spouse) to use all or a portion of your 2024 federal estate and gift tax exemption that excludes up to $13.61 million of gifted assets from federal estate tax. Due to restrictions on gifting certain types of equity compensation (including RSUs, RSAs and ISOs), the cleanest path for transfer tax planning involves gifting outright shares, if such gifts are permissible under applicable federal and state laws.
Post-IPO Sales
Once a company is public, executives may imagine that it gets easier to sell their shares. However, lock-up periods restrict employees from selling shares immediately post-IPO, and corporate executives can often only sell shares during “open trading window” periods—usually for four to six weeks after each quarterly earnings release. Even during those times, material non-public information provisions, as well as company-specific agreements, may prohibit executives from transacting in company stock.
For these reasons and more, executives and other insiders may benefit from working with an equity planning specialist to devise liquidity strategies geared toward their personal circumstances.
A Customized Approach
Managing the many variables leading up to a liquidity event can be complex, and your executives may have particularly nuanced financial needs. To learn how Morgan Stanley at Work can help, explore our Executive Services offering.
