Equity Awards for Startup and Small Business Employees

Do you know that windows exist in an early-stage startup or small business that enable you to take action—and lower your tax bill?

Although it’s unpleasant to think about, your company may be shielding you from information you need to make successful financial decisions and set yourself and your family up for the future. In fact, some people in upper management believe employees should never plan for a possible liquidity event.

A former chief operating executive at three Fortune 100 companies who has sat on many startup boards of directors shared this with me:

We used to go out of our way NOT to prepare employees for any liquidity because of the shareholders’ desire to keep them focused on the company’s mission, and also because of the uncertainties involved. Preparing employees in advance of an event, unless it is in one of the small handful of rare and very mature situations (such as Google or Facebook), is probably not in the company’s interest.”

Since it is clear many in management want to employees to stay focused and keep shipping, it’s important that startup and small business employees understand what they own and what to do with it.

Waiting until after a liquidity event is too late. Exercising low-priced stock options and creating a cash flow plan are two important actions to take in the early phases of a startup.

Here are definitions of a handful of common equity awards, and some of the proactive moves you can make.

Incentive Stock Options (ISOs)

Upon grant date, there are generally no tax consequences. Upon exercise, you do not recognize taxable income for regular tax purposes. However, the spread between the fair market value (FMV) on the date of exercise and the stock purchase price (the “bargain element”) is taxable for alternative minimum tax (AMT) purposes. You must hold the stock for two years from the date of the grant and one year from the date of exercise to have a qualifying disposition. A gain on the sale of ISOs in a qualifying disposition is taxed at the favorable long-term capital gain rate.

Non-Qualified Stock Options (NQSOs)

Upon grant date, generally there are no tax consequences. Upon exercise, you recognize ordinary income (generally subject to payroll taxes or self-employment taxes) to the extent that the FMV of the stock on the date of exercise exceeds the strike price. As long as your company's plan allows it, you may exercise your options before they are vested by making a special election with the Internal Revenue Service (an 83(b) election is done to start the clock ticking for long-term capital gains).

Restricted Stock Awards and Restricted Stock Units

If you are granted restricted stock awards (RSAs) or restricted stock units (RSUs), there are no tax consequences at grant date. Upon vesting (or lapse of other restrictions), you receive shares of company stock. These shares are taxed at your ordinary income tax rate based on the value of the shares received. It’s more common for larger companies than startups to issue RSUs or RSAs than stock options.

Employee Stock Purchase Plan (ESPP)

Employees pay tax at ordinary income tax rates on the discount amount when shares are purchased and capital gain upon the sale of the shares. The amount of the employee discount, or the difference between the price paid and the fair market value on the date of purchase, will be included on your W-2. When you sell the shares, the capital gain may be taxed at the lower long-term capital gain rate, depending upon how long you held the shares. Remember to add the employee discount reported on your W-2 to the amount paid for the stock when calculating your gain on your tax return.

Understanding your equity award inventory, and how each grant is taxed, can save you money and increase your wealth.

This article is adapted from Joyce L. Franklin's book Life, Liquidity & the Pursuit of Happiness: How to Maximize and Preserve Your Startup Wealth and Live Your Dreams, where you'll find plenty more tax and financial planning tips related to stock and equity awards.

Joyce L. Franklin, CPA, CFP®, is the founder of JLFranklin Wealth Planning. She is also the author of Startup Wealth: The Entrepreneur's Guide to Personal Financial Success and Long-Term Security, available in print and ebook editions on Amazon. A longtime advocate for financial literacy, Joyce advises many executives and high-tech entrepreneurs and blogs for The Huffington Post. An alumna of Deloitte and Ernst & Young, she has nearly two decades of personal financial planning experience and more than 25 years of tax expertise. Joyce holds a Graduate Certificate in Personal Financial Planning from the University of California, a Master of Science in Taxation from San Francisco State University, and a Bachelor of Science in Commerce from the University of Virginia.

Follow Joyce on Twitter @JoyceLFranklin.