Paulsen’s Startup Stock Bill Passes The House

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By Bobby Franklin, TechCrunch

screen-shot-2016-10-18-at-11-10-35-am“On any given day in our nation’s capital, you’ll find many lawmakers touting the benefits of entrepreneurship.  Unfortunately, this enthusiasm is all too often forgotten when it comes to our nation’s tax policy, which often either ignores or is outright hostile towards startups.

That is why when legislation does gain traction to massage the tax code to the benefit of startups and their employees, it’s worth cheering from the hilltops.  As I write, there is legislation quietly making its way through Congress that could take a very productive step towards creating a tax code that supports entrepreneurship.”

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Comments

  • Daren Cotter

    Happy to see local rep @RepErikPaulsen championing this effort. Current tax code forces employees to make challenging decisions re: stock options, which makes it more difficult for companies to share upside with employees.

    • http://tech.mn Jeff Pesek

      Can someoone provide an ELI5 on this?

      Curious to understand just what this means for entrepreneurs in the trenches right now…

      • Zach Robins

        It’s a smart solution to a real problem and
        has strong bipartisan support as well as backing from NVCA. Simply put – startups cant afford to pay going rates for talent, so they incentivize through
        options…and by the Gov’t potentially allowing employees to defer the taxes owed on exercised options for up to seven
        years, employees have some relief from the tax burden and the startups are able to be that much more competitive in hiring talented
        individuals!

      • Daren Cotter

        Here’s some info regarding the current issue. Hopefully someone with more knowledge on the proposed legislation can chime in with details. Disclaimer: I’m not an accountant or lawyer so don’t act based on this.

        Common scenario that plays out: startup employee gets stock options priced at the company’s fair market value, probably based on their Seed financing round (let’s say $3 million). Stock options vest over a period of time, typically 4 years. When stock options vest, the employee can exercise their option and buy the stock. There are lots of reasons an employee may want to exercise:

        1) They leave the company, in which case they typically either have to exercise within 90 days or lose their stock options.
        2) They want optimal tax treatment in the event the company is acquired. Stock held for more than a year is taxed at the lower capital gains rate, whereas options that convert into stock at the time of an exit would not be held 1 year and thus taxed at higher ordinary income rates.
        3) Shelf life of an ISO stock option cannot be longer than 10 years, per IRS regulations.

        Continuing with the scenario. The company has done well, and valuation has grown from $3 million to $30 million. For one of the above reasons, the employee wishes to exercise their options. The issue that occurs is that the spread between the strike price the options were initially granted at, and the stock’s current fair market value, gets treated as taxable income to the employee. In this case, if the employee was given 2% of the company via stock options, their taxable income is $30M-$3M=$27M*2%=$540,000, which would likely result in tax owed of $200K+. But the employee never received cash, there’s no market for the private company stock (and usually restrictions on selling anyway), AND…still a chance the stock ends up being worthless. So it’s very unlikely they can afford, even if they wanted to, this kind of tax bill.

        • Ben Pedersen

          This is a good explanation. It leaves out some weaknesses of the legislation, which I’ll do my best to explain. Disclaimer: I’m also not an accountant or lawyer.

          First, the tax liabilities can only be deferred for a max of 7 years. Since liquidity events are taking longer to happen, this cap can cause the same problem the legislation is trying to fix, where the employee doesn’t have the cash to pay the tax bill. Sure, there’s some relief in the fact that the employee has 7 years to financially plan for this tax bill. However, it can also encourage an employee to make a risky decision to exercise their option, assuming a liquidity event will happen in time, and then be stuck with a tax bill they can’t pay if the liquidity event is delayed.

          Second, Daren brought up there’s a chance the stock ends up being worthless. The legislation does nothing to help with this. Using his example, there’s a $200k+ income tax liability when the employee exercises their stock option and the legislation would let you defer that liability. However, if that stock goes to zero, it is a $600k capital loss and only $3k of that can be deducted from taxable income each year. The result is the employee most likely still has to pay a $200k+ tax bill seven years after exercising their stock options even though that stock is worthless when the bill is due.

          Note, this legislation doesn’t cause either problem. It does make them more likely to happen since a tax deferment will encourage more employees to exercise their stock options (and to take options in place of salary), even perhaps when they shouldn’t.

          As an entrepreneur who plans on hiring people in the next few years and will need to figure out compensation before that, these problems make me really apprehensive to include stock options as compensation.

          • Frank Jaskulke

            Ben – You can deduct capital losses against capital gains. The $3000 limit is how much capital loss can be deducted against other incom – like wages.

            So if you lose $600k and gain $200k you are not going to have a capital gain to pay tax on – assuming they happen in the same tax year.

          • Ben Pedersen

            Frank – The $200k is not a capital gain. It is the tax due on originally exercising the stock option. When the employee exercises the stock option, the difference between the strike price and the market price of the stock counts as ordinary income and not a capital gain.

          • Frank Jaskulke

            Oh! Well then that sucks.

  • Harold Slawik

    The legislation looks like a vehicle for fixing a problem with ISOs. As originally designed, ISOs are a great way to encourage employees to exercise and hold company stock. Unfortunately, the benefit of ISO status has been effectively gutted by inflation over the last several decades.

    ISOs incent employees to exercise and hold company stock by eliminating the ordinary income tax that would otherwise accrue upon exercise. Without ISO status, the tax is the difference between the option strike price and the FMV of the stock on exercise—this is how the tax works for regular or so-called “non-statutory options” granted to contractors. And you read that right, ISOs eliminate that tax, not just defer it.

    The problem with ISOs is that the tax that’s forgiven has to be included in an individual’s AMT calculation. As the AMT income thresholds have come down over the years with inflation, the benefit of ISO status has been largely eliminated. What’s excluded from ordinary income due to ISO status just ends up getting added back to income via the AMT.

    The lack of IPOs obviously makes things worse since employees exercising don’t have liquid stock to use to pay the tax.

    So, ISOs are still a great concept and a great vehicle for employees. The 7-year deferral sounds like a good way to patch the AMT problem, and encourage employee ownership in general. It would be great to see a broader overhaul of the AMT, but that’s another matter.

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