Technology sector startups and other emerging growth companies that typically rely on equity compensation to attract talent should be relieved—for now—by the Tax Cuts and Jobs Act bill (HR 1) passed by the House on November 16 and Senate Finance Committee Chairman Orrin Hatch’s mark of the Senate bill1.
The initial versions of both the House and Senate tax reform bills had proposed a novel and somewhat punitive approach to taxing equity compensation that many worried would have hamstrung the ability of startups to effectively compensate their employees.
The provisions of those versions of the bills would have accelerated the taxation of nonqualified stock options and RSUs as income upon vesting—yes, upon vesting, as opposed to upon exercise of the options or receipt of the stock underlying the RSU—thereby creating immediate non-cash taxable income for employees as their equity awards vest over time, and effectively turning these awards into burdensome tax liabilities2. Other provisions of the bills would also have essentially gutted nonqualified deferred compensation.
Many in the emerging growth business community voiced concern that such changes would threaten startups’ ability to recruit, compensate and retain employees, who might not be able to pay accelerated tax to the extent they had yet to receive cash income from their vested stock options or other vested deferred compensation. Executives in tech and other industries rely on the deferred compensation tax benefit, and its repeal would represent a significant change to current tax law. More than 600 tech sector companies signed a letter calling on legislators to remove the accelerated tax and deferred compensation provisions from the bills entirely. So far, Congress appears to have responded.
The House-passed bill and Sen. Hatch's current mark of the modified Senate bill provide that nonqualified stock options granted at fair market value will, if certain conditions are met, continue to be taxed when such options are exercised, and deferred compensation will continue to be taxed when paid. Notably, the latest versions of both the House and Senate bills also contain a new protection for certain emerging growth company employees who exercise their equity awards. If enacted, these bills would permit certain non-executive employees to elect to defer tax recognition of compensation income from the exercise of nonqualified stock options or settlement of RSUs for up to five years3.
This new provision, however, may have limited practical effect in its current form as many C-suite executives (the CEO, the CFO and anyone who was one of the four highest paid employees of the employer during any of the last 10 years) would be prohibited from electing to defer recognition of such income, and the employer would need to establish a written plan under which at least 80 percent of all employees providing services to the employer are granted similar stock options or RSUs. Additionally, employees would remain eligible for the favorable tax treatment afforded to ISOs, which not only defer the recognition of income, but also subject gains on stock over the exercise price to favorable capital gains tax rates if the applicable holding period is satisfied. Neither the House-passed bill nor the current Senate version would alter the ISO provisions of the tax code4.
The Tax Cuts and Jobs Act is evolving rapidly and Dentons will continue to closely monitor further legislative developments.
1. Sen. Hatch's current mark of the modified Senate bill, released on November 14 and expected to be voted on after the Thanksgiving holiday, contains equity compensation treatment provisions that are largely in line with the provisions of the House-passed bill.↩ 2. Currently, employees are taxed on stock compensation when the stock is transferred to the employee and is no longer subject to a substantial risk of forfeiture. Generally, nonqualified stock options are taxed upon exercise and restricted stock units (RSUs) are taxed when the underlying shares are released. Incentive stock options (ISOs) are not taxed until the employee sells the stock acquired upon exercise of the ISO.↩ 3. An employee who elects to defer the recognition of compensation income on stock issued upon exercise of nonqualified stock options or in settlement of RSUs would be required to recognize such compensation income on the earliest of (i) the date the employee becomes the CEO, the CFO or one of the four highest paid employees of the employer; (ii) the date the stock first becomes transferable (including to the employer); (iii) the date the stock becomes readily tradable on an established securities market; (iv) five years after the date the employee’s rights to the stock becomes transferable or otherwise cease to be subject to a substantial risk of forfeiture, whichever occurs first; or (v) the date the employee elects to recognize such income.↩ 4. Under current law, the excess of the fair market value of the stock over the exercise price (the "bargain element") of an ISO at the time the option is exercised is includable in income for alternative minimum tax purposes. The current versions of both the House bill and the Senate bill would eliminate alternative minimum tax, which would make ISOs more favorable for those employees who would be subject to alternative minimum income tax under current law.↩