Tax Treatment of Stock Options and RSUs
by Iche Chiu
Many of you have stock options and RSUs; however, the tax treatment associated with it is a little more complicated than you may think- especially, when the statements or schedules received conflict with each other. If you feel the pain, it worth your time to read this article.
Being a part of the startup team or investing in early-stage companies can be a rewarding experience. Along with the excitement of creating new things, people who put their efforts on the early-stage companies usually receive payout in terms of stock options and RSUs (restricted stock units). Although, unfortunately, many startups struggle to hit the projection and grow to the point as the founder expected. The stock options and RSUs will be worth so little (if not nothing) for a long time. However, in cases where the company is bought out or a new round of financing gives a much higher valuation, those stock options and RSUs might be cashed out with significantly higher amounts. And of course, when that happens, taxes come along.
Depends on your role within the company, either as an employee or a passive investor, the cash payout and tax withholding will be different. If you are an employee of the company and received stock options under an incentive stock options grant (ISO), usually there won’t be any tax triggered at the option grant date or the exercise date. You will have the preferential capital gain tax treatment if you sell the stocks in a qualifying disposition. With the proper tax planning, the cash outlay can be maximized. However, minimizing the ultimate the taxes might not always be the only goal, other factors need to be considered. For example, if you are risk-averse and want to minimize the exposure to a concentrated position, then holding the stocks long enough to meet the qualifying disposition rule may not be ideal for you.
There are also cases that stocks are granted directly to employees or consultants as compensation for their services. Usually there are some restrictions on those stocks, such as a vesting schedule. Generally, you will be subject to taxes when the stocks are fully vested, or in other words, when the substantial risk of forfeiture lapses. 83(b) election is an effective tax planning tool to maximize the portion of earnings that subject to the preferential capital gain treatment. In either case, it’s always advisable to keep good documentation of the stock cost basis.
For passive investors of the startup companies, convertible note is a popular instrument to fund the company. When the terms are met under those instruments, such as a buyout of the company, the taxes will be trigger as well. The companies may not withhold taxes for you in such cases, therefore planning ahead is important to avoid the potential estimated tax penalties.
Written by Iche Chiu