ESOP Taxation: What startups should know?
This article is meant to provide you with a comprehensive overview of ESOP taxation.
ESOP, or Employee Stock Ownership Plan, is a form of equity award granted by a company to its employees. The adoption of stock-based compensation has been expanding in recent years. Startups recognize ESOPs as an excellent tool to attract and retain employees. You might be wondering what is the process of taxation associated with ESOP. Well, this article is meant to provide you with a comprehensive overview of ESOP taxation in order to guide you on your options, requirements, and obligations for employing an ESOP in your startup.
ESOP taxation and startups
ESOPs have been used by startups for a long time now to attract and retain employees. Often, the lack of funding prevents startups from recruiting or retaining employees. A startup with an ESOP in place has more incentive for its employees to work hard and contribute their best efforts toward the company’s success. However, there are certain rules and regulations that come along with an ESOP, especially taxation rules. Essentially, ESOPs are stocks that have a vesting schedule and a restricted period. Therefore, ESOPs are taxed in two cases, first in that particular year when the employee acquires the shares, i.e., at the time of exercising and, secondly, at the time of selling the shares.
What is ESOP?
ESOP is a form of equity compensation plan that’s based on the concept of stock ownership, in which the company issues shares to its employees, typically with a vesting period. The underlying motive behind an ESOP is to make the employees of a company become vested stakeholders and to help or retain them in the company. As a matter of fact, the vesting schedules of ESOPs are often an important part of the employee retention strategy. Thus, employees are more likely to work hard for a company where they are vested.
How does ESOP work in startups?
For a startup to have an ESOP, the company has to follow some specific guidelines and provisions. In fact, proper planning and structuring around the ESOP are essential before you decide to adopt an ESOP. Well, the employer is required to decide the number of shares to be issued, the price of the shares, and the vesting schedule. Basically, a trust fund is created on behalf of the company, wherein the shares are held till the time the vesting period is completed.
When the vesting period is completed, the employee can buy and exercise the shares at a price allocated. The mechanism of ESOP ownership is based on the vesting schedule and acts as a legal commitment on the part of the employee. However, in the case of employee termination, the employer is required to buy back the shares within 60 days.
Importance of ESOP in startups
An ESOP is a simple yet efficient way of making the employees vested in the company. It has been observed that companies adopting an ESOP are more likely to retain their employees, and this improves employee satisfaction as well. Following are a few other importance of ESOP in startups:
- The sense of ownership and the resulting commitment to the company usually improve employee morale, which leads to greater productivity.
- The low and slow ownership transition can help you build a long-term relationship with your employees.
- The financial gain that the employees see after equity vesting is likely to motivate them to work harder and contribute more to your company.
- In order to attract top talent to your startup, use this instrument of equity incentives to retain your employees.
Understand ESOP taxation
Now that you know the concept of ESOPs, it’s time to look at the taxation aspect. In general, ESOP is taxed in two instances, at the time of vesting and when the employee sells the share. Be it the case of vesting or selling, the employee is required to pay the respective taxes and report the same to the concerned authorities. However, the calculation of ESOP taxation in both cases is different due to the fact that at the time of exercising, it is taxed as a prerequisite, while at the time of selling the shares, it is treated as capital gains.
ESOP Tax Policy
The government updated the tax code in 1996 and 1997 to allow ESOPs to own an S corporation as well. S corporations are excluded from paying federal corporate income tax under federal law. Several states have included this clause in their respective tax codes. As a result, an ESOP that holds a full stake in an S corporation may not be subject to any corporate income. But according to financial experts, S corporation ESOPs outperform their non-ESOP counterparts in terms of productivity and sales, generating a net $8 billion increase in revenue for the federal government annually.
What is the need for ESOP taxation?
An ESOP is a popular form of employee compensation that provides employees with interest in their company. In terms of taxation for ESOP, there are various benefits. Following are a few reasons why taxation on ESOP is good for the company:
- Stock contributions are tax-deductible, thus, companies can issue new shares or treasury shares to the ESOP and gain benefit from the increase in current cash flow, though this will reduce the ownership of existing shareholders.
- Dividends are deductible for tax purposes if they are used to pay back ESOP loans, distributed to employees, or invested back by employees in company stock. As a result, companies will save on tax liability, as well as gains from shares held by the ESOP.
How does ESOP taxation work?
Basically, the fact that an ESOP is a form of stock ownership means that the employee must pay the tax for it as taxable income and capital gain or loss. While there are two types of stock options, thereby implying different tax treatments. To better understand the process of ESOP taxation, we will examine the two types of stock options. Below is a detailed description of each type of stock option:
Statutory stock options
The options granted by a company under an employee stock purchase plan or an incentive stock option (ISO) are treated as statutory options. Under the statutory stock option, employees are not liable to include the amount in their gross income at the time of exercising or receiving the option. However, upon exercise, the employee is subject to an alternative minimum tax in that particular Additionally, at the time of selling the stock that has been exercised, capital gain or loss is calculated accordingly.
At the same time, in the case when you are not fulfilling the requirement of a special holding period, income will be treated as a sale from ordinary income. Further, you are required to add the same to the basis of the stock, which is treated as wages in determining the gain or loss on the stock’s disposition.
Now let us look at the important forms to be filled after exercising ISO and ESOP:
- After exercising ISO, Form 3921 is to be filled by the employer, wherein it will state the dates and values that are used for the purpose of determining the amount of capital and ordinary income (if applicable) further which is reported.
- After exercising an ESOP, Form 3922 is to be filled, which is similar to Form 3921, however, in this case, ordinary income is always applicable.
Non-statutory stock options
For non-statutory stock options, it is neither granted under ISO nor ESOP. As we know, in private companies, the FMV of shares is not readily available due to the fact they are not listed on any stock exchange. Therefore, there is no tax obligation at the time of grant, however, when exercising or selling the shares, the same is taxed. At the time of exercising an option, the difference between the FMV and strike price is included in the income, while at the time of selling the shares, capital gain or loss is calculated.
Key terms to know before ESOP taxation calculation
We have already seen the steps required to be followed for ESOP taxation. However, before you start filling out the tax return forms, it is important to understand and know the terms of ESOP taxation. The following lists the terms that are used while calculating taxes on ESOPs:
- ESOP Taxation – ESOP or Employee Stock Ownership Plan is a form of stock-based incentive which gives the right to employees to buy the company’s shares after a particular period of time. Essentially, an agreement is signed between the company and the employee, along with specific terms and conditions.
- Vesting Date – It is the date on which an employee becomes entitled to exercise their right under the ESOP. While it is essential that the terms and conditions are agreed upon to issue a vesting date, this is an agreed-on grant date of the ESOP.
- Vesting Period – This is the period in which a share of stock must be held before ownership of the shares under the ESOP is vested. It is usually based on the achievements of the employee and the provisions of the ESOP. Thus, as per the ESOP and the vesting agreement, it could be from months to years.
- Exercise Period – After the vesting period is over, this is the time period in which the employees take a right to buy shares under ESOP. It basically starts when the employee vested ends once the conditions of the vesting period have been fulfilled. However, it is essential to remember that this gives the right and not the obligation.
- Exercise Date – It is the date when the employee has a chance to exercise the right given in their agreement. As this is an agreed date, it could be the same date as well as any other day decided upon. It is an important step as this is the time when the employee may take the right to receive a number of shares.
- Exercise Price – This is the amount at which the shares are purchased under ESOP. It is generally equal to the FMV of the shares on the date of exercise. However, it can be lower than the FMV of the shares, depending upon the agreed terms.
Considerations to calculate ESOP tax
While calculating the tax liability on ESOPs, some other aspects must be considered, and these include:
- Short and long-term gains – Once the shares are granted, the employee can either hold it for short-term, i.e., less than one year, or long-term, i.e., more than one year. Short-term gains are similar to ordinary tax rates that range from 10% to 37%, depending on the employee’s income and filing status. While for long-term capital gains, the tax rate is generally lower, ranging from 15% to 20%.
- Loss – If there is any loss, it can be deducted and adjusted from the future capital gains when the employee reports the same as a short-term capital loss in the tax return. However, this totally depends on future capital gains. As a result, if the employee has no future capital gains, they cannot adjust any loss.
- Vesting date – Normally, in stock options, the shares are vested over a period of time. The vesting date is the time at which the employee becomes eligible to exercise the options. The employee gets to know about the vesting date on the grant of stock options which is typically included in the agreement.
Calculate FMV for ESOP taxation
After understanding the terms of ESOP taxation, let us look at how the fair market value (FMV) of shares is determined for the purpose of taxation. Well, a 409A valuation is used by private companies in order to determine the FMV of shares. As a matter of fact, FMV is the significant component that is used to calculate the exact amount of tax obligation. While under 409A valuation, the FMV can be calculated using various standardized methods such as asset-based approach, market-based approach, income-based approach, or backsolve method. Thus, the FMV should be calculated accurately as per the rules and regulations of the Internal Revenue Service (IRS).
How does 409A valuation help calculate FMV for ESOP taxation?
As we know that the shares of private companies are not listed on any stock exchange, and there is no market data available. However, private companies can use 409A valuation for determining the FMV of shares and subsequently can be used in calculating taxes under ESOP. As an employer, in order to make things easier for you, it is advisable to hire a third-party professional like Eqvista to determine the FMV. With professionals on your side, you can avoid the hassle of dealing with complex calculations and work towards a successful ESOP.
How does advance tax work on ESOP?
In the case of capital gains under ESOP, the tax that is due for the entire year should be paid in advance, this is known as advance tax. Moreover, it can also be paid in equal installments, generally, it is paid in advance. However, if the sale was made later in that particular year, estimating the tax on capital gains and depositing the same in advance as installments can be complicated and difficult.
Thus, it is essential to note that no penal interest is charged in the case when the installment falls short as a result of capital gains. While the remaining installments after the sale of options must include the tax that is required on the capital gains.
When is a tax required on ESOP?
A tax on an ESOP is required in two instances, at the time of exercising and when the stocks are sold. Here is a brief explanation of each.
- When exercising the options – In the case of incentive stock options (ISOs), there is no taxable event at the time of exercising the options. However, your employee might be subject to Alternative Minimum Tax (AMT) when the options are exercised and the stocks are not sold in the particular year. On the other hand, Non-Qualified Stock Option (NSO) exercises are considered taxable events. At the time of exercising NSO, the employee is required to pay the ordinary income tax on the difference between the exercise price from the fair market value of the stock at that point in time. However, NSOs are not subject to AMT.
- When selling options – In private companies, the stocks are generally sold via tender offer (the company can allow the employee to sell the stocks to investors or a group of investors under tender offer), or the company might buy back the shares, known as repurchasing. As a result, after exercising the options, the employee decides to sell the stocks irrespective of the nature of the stock options. When the selling price should be more than the purchase price, it will be considered a capital gain tax. Depending on the holding period, the following taxable event takes place:
- When the holding period is longer than one year after the date of the exercise or 2 years after the grant date, the employee is then required to pay the long-term capital gains taxes. However, the tax rate is generally low for long-term capital gains. The employee is required to fill out Schedule D of Form 1040.
- In the case of a holding period of less than one year, for NSOs, the ordinary income tax is applicable. For ISOs, when the employee makes a sale of the stock within 12 months, but over two calendar years, AMT will be imposed on the difference between the exercise price and the FMV of the stock at the time of the exercise. Fill out Form 6251 for AMT, and Form 1040 for ordinary income tax as wages.
Calculation example of ESOP taxation at the time of distribution
Let us consider the case of Michael, who is an employee at TTG Inc. On 1st July 2020, Michael and his employer signed an agreement with ESOP. The agreement states that Michael will be issued 10,000 shares at the price of $10/share on 1st July 2020, for which he will have a vesting period of 2 years (2 year cliff), and he will be entitled to exercise from 1st July 2022. Well, on 1st July 2022, the FMV of the share is $20. The following calculation methods are mentioned below to help you out in the ESOP taxation calculation on Michael’s 10,000 shares:
- Agreed-upon price or strike price – $10 per share
- Vesting period – 2 years
- FMV of share on exercise date – $20
- Number of shares allocated – 10,000
Now, ESOP taxation will be treated as a prerequisite, and the formula is (FMV per share – strike price per share) x number of shares allotted. In the above case, as per the formula:
- (20-10) X 10,000
- Amount of tax liability = $100,000
Thus, the amount of $100,000 should be added to Michael’s income and accordingly be taxed in that particular year of 2022.
Get expert help on ESOP taxation from Eqvista!
While ESOP tax calculation may seem easy at first glance, however, the actual process is quite complicated and requires skilled and professional help. Hence, if you are looking to issue your employees with shares under ESOP, then taxation associated with ESOP is going to be a hassle for you. Get it resolved with the help of an expert like Eqvista and avoid the complexity of tax calculations. Whether it is 409A valuation, stock option pricing, or ESOP taxation, Eqvista is your go-to company for all your valuation and tax needs. Our tools and experience ensure the most accurate guidance and results, providing a smooth tax planning experience for our clients. Contact us to know more!