Stock options are a very popular part of executive compensation packages but some tax rules make it difficult for employees of start-up and private companies to exercise their options and take control of their ownership stake. To broaden access to stock options for these businesses, U.S. Sens. Mark R. Warner (D-VA) and Dean Heller (R-NV), have introduced bipartisan legislation that would defer tax on stock options for seven years, making it easier for startups and other small businesses to give employees an ownership stake in their company. Identical legislation was also introduced in the U.S. House of Representatives by Rep. Erik Paulsen (R-MN).
Under current law, employees are required to pay taxes when they exercise their options or when their restricted stock vests. (See box below for exceptions.) Employees pay taxes on the difference between the amount paid and the fair market value of the stock. The employer receives a deduction on the date the employee exercises the option. For companies that are publicly traded, employees can sell their shares on the public market to pay their taxes. However, for privately-held companies, there is not always a market for employees to liquidate shares to cover the tax. As a result, employees may be unable to exercise their stock options.
Stock Option Basics
Stock options are a right to purchase shares of a company at a future time at a fixed price and are an important tool for rewarding employees and increasing their compensation. There are two categories of options, statutory and nonstatutory, which carry different restrictions and different tax consequences. Nonstatutory stock options are taxed at the time of exercise but others, such as statutory options given under large corporate incentive stock option plans, are not. The new legislation would create a special category of nontaxable stock option.
New Legislation Gives 7-Year Deferral
The companion bills, S. 3152 and H.R. 5719, the “Empowering Employees through Stock Ownership Act”, set up a special rule for stock options offered to employees of start-ups that would give employees up to seven years after exercising their stock options to pay the tax. To promote broad-based employee ownership, the options must be offered to 80 percent of the workforce for the deferral rule to apply. The stock cannot be traded on an established market. Further, individuals who own one percent or more of the company and those who control the company, such as the Chief Operating Officer, the Chief Financial Officer, and the four most highly compensated officers, would not be eligible for deferral.
The employer will be required to report the future tax liability on the employee’s Form W-2. If the stock becomes readily tradable on an established market, or if the employee decides to sell or transfer the shares before the seven-year time period ends, the employee will have to pay the tax. An employee also could revoke the deferral and pay his or her income tax at any point.
In introducing the bill, Sen. Mark Warner said, “Extending employee stock programs to a broader universe of workers will strengthen business growth and create new economic opportunities, especially for rank-and-file workers.”
Single-issue tax bills rarely make it through the legislative process. This bill, however, has bipartisan support and is sponsored by two members of the Senate Finance Committee and one member of the House Ways and Means Committee, the tax writing committees of Congress. Look for an attempt to include it in future omnibus tax bills.
About the blogger
Lucia Nasuti Smeal is a guest blogger on tax topics for Frazier & Deeter. Smeal is an attorney, a tax Professor with Georgia State University’s J. Mack Robinson College of Business, and former editor of Tax Notes Today, published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker on current tax developments.