Complete Tax Guide for Startup Equity in the USA

The percentage of a startup’s shares sold to investors is called startup equity. As a result, investors will receive ownership and rights to the startup’s potential profits. It is typically given out in the form of stock options. As a startup grows in popularity, all subsequent investors will be willing to pay more per share in subsequent funding rounds. This is one of the factors that encourages startups to expand.

The most common scenario is when co-founders share ownership in percentages. These four categories may be used in different combinations by different startups. However, not all startups give advisors, investors, and employees ownership. In this article, we shall cover in depth the startup equity tax, tax implications in startup equity, equity compensation tax treatment, how equity gets taxed in startup & more.  

Equity tax and startups 

While it may appear premature to plan for tax reductions when you’re just getting started, there are a few key tax-related decisions that many startups and their founders should make right from the start, given the high growth potential. Cost-cutting tax planning becomes much more difficult to implement once your company has grown to the point where an IPO, merger, or acquisition is a likely event.

Understand startup equity

The investors as equity holders receive a much larger share of the pie than advisors/mentors, employees, and sometimes even co-founders. Among the various types of investors are, but are not limited to:

• Angel financiers
• Investors in venture capital
• Relatives, or close friends

Because their primary role is to give money, these investors receive the highest percentage of equity. They are taking a huge risk by investing money in a startup that is not guaranteed to succeed; therefore, they deserve a proper reward.

How does startup equity work, and what is the importance of having it

Making difficult decisions is almost second nature to entrepreneurs. From figuring out how to raise valuable capital to cut ties with bad employees or bad clients, the security and longevity of their emerging businesses are top of mind. However, startup founders must overcome employee compensation and equity distribution, arguably the most important challenges.

Poorly allocating company shares in the early stages of a startup can lead to disaster later on. While carefully building an initial team of employees is critical in establishing a solid organizational framework, determining an appropriate equity structure for the startup’s first workers can establish the right employee retention culture and pay significant future dividends. Forming and dividing proper startup equity helps avoid foundational issues in its growing phase. 

Types of Equity in Startups

Following are the various types of equities in a startup with their different type of functionality:

• Incentive Stock Options (ISOs) – ISOs are subject to stringent restrictions on who can be issued, whether they are transferable, & how much stock can be exercised. ISOs can only be issued to employees, & the company that issues the ISO cannot claim a tax break.
• Non-qualified Stock Options (NSOs) – NSOs are taxed both when they are exercised and when they are sold. Employees granted NSOs must spend on ordinary income taxes on the difference between the grant price & market price. On the other hand, ISOs are only taxed on the sale of stock and have less stringent valuation requirements.
• Restricted Stock Units (RSUs) – Restricted stock units, or RSU are similar to restricted stock awards. Employees don’t receive the stock until certain conditions and requirements are met. However, because income taxes apply to RSUs, employees can’t be taxed at a lower capital gains tax rate.
• Restricted Stock Awards (RSAs) – RSAs, or restricted stock awards, are among the most straightforward options because no stock pricing is required. Employers provide restricted stock shares that employees can’t sell or transfer until certain conditions and requirements are met. The share transfer happens at the current cash value. Only after the timely filling 83b election the fair market value on the vesting date, or the date when the employee is not at risk of forfeiture, is considered taxable compensation income.

Understand strike price and vesting schedule 

If you earn ISOs or NSOs, your strike price is the cost of purchasing or exercising a single share of your company’s stock. For example, if you earn 5,000 ISOs at a strike price of $1, exercising all 5,000 shares will cost you $5,000 (before taxes). Your strike price is fixed when you are granted stock options and doesn’t change during the grant term. 

In contrast, vesting is a financial term when your options become available for exercise or purchase. Many startup employees earn stock options under a 4-year vesting schedule with a 1-year cliff, which is the most common vesting schedule. Typically, you will vest 25% after one year, with the remainder vesting monthly or quarterly over the next four years.

That is, if you are granted 5,000 stock options at the outset, you will be able to purchase 1,500 shares one year later — your “cliff”. After that, you’ll be able to purchase additional shares monthly or quarterly. You will be able to purchase all 5,000 shares after four years.

Why is choosing early exercise options important?

Early startup employees are frequently given stock options. It can be converted to stock by paying the exercise price. When a company allows for early exercise and says the share price is low enough, employees might be able to exercise their options right away. This can result in significant tax savings.

Employees who exercise their options early will be able to keep their shares for longer, allowing them to be taxed at lower long-term capital gains rates. However, if they exercise early and do not file Form 83(b) with their tax returns, the IRS will not recognize ownership of the share until it has fully vested.

Exercising options early may also qualify founders and early employees for the Qualified Small Business Exemption. This exemption allows people with certain requirements to avoid federal taxes on capital gains of up to $10 million. 

Startup equity taxation

Ordinary income tax on the current valuation and the strike price difference when you exercise your options. When you sell, the tax applies to the sale price and the valuation difference at the time of exercise as long-term capital gains. Hence, you should try to minimize the difference between the strike price and the exercise price. Do this as soon as possible if the startup is successful.

Why should you file for startup equity tax?

The most prudent thing for startups is to plan how to treat equity well before any potential liquidity event and ensure that employees understand the tax implications of exercising options. Companies should also take the time to determine whether an 83(i) plan is right for them, and they must consider the administrative burden before proceeding. The new tax law is complicated, and changes in one area can ripple and affect both companies’ and individuals’ tax liabilities. Mapping out the impact of these changes is critical for informing any future tax strategy.

How does AMT affect startup equity holders? 

AMT stands for the alternative minimum tax & let’s just say it has a complicated past. Startups granted ISOs to employees as much as possible during the early internet era. Many of the employees have no idea how AMT works. Employees exercised them in the dot-com era when stock prices or valuations were very high but would not sell or could not sell. The market then crashed, and their stock was worth almost nothing. However, their tax bill remained unchanged because it was predetermined at the time of filing.

When to file 83(b) tax election?

Let’s talk about whether or not you should file an 83(b). On the surface, paying taxes on stocks that haven’t even vested appears counterproductive. It can save you a great amount of money when used correctly. Two factors influence the decision to go through an 83(b) election:

• Are you able to afford it?
• Do you believe the startup will be successful?

Let us understand how an 83(b) can be useful under the following conditions –

• Startup growth – Your startup is rapidly expanding, and shares are worth $2 after the first year and $4 after the second. Remember that if you make an 83(b) election, your taxable income in Year 0 is $110,000, and your taxable income in Years 1 and 2 is $110,000. If you omit the 83(b), your taxable income is $100,000 in Year 0, but it rises to $110,000 in Year 1 (salary plus $2 * 5,000 vested shares) and a whopping $120,000 in Year 2 (salary plus $4 * 5,000 vested shares). Making 83(b) is a better option in this case.
• Startup declines – Assume the company isn’t doing well and shares are worth $0.50 after one year and $0.25 after two years. Without the 83(b), your taxable income is now $102,500 after Year 1 and $101,250 after Year 2. Choosing 83(b) costs you more money. You can deduct the amount you overpay, but only as a capital loss, which means you can only apply it to capital gains made that year. If your overpayment exceeds your capital gains the following year, you’re out of luck.

How is startup equity taxed?

If you decide to buy (or exercise) your ISOs or NSOs, you will almost certainly owe taxes on the transaction.

Both stock options require you to take your strike price, compare it to the company’s most recent 409A valuation, and pay taxes on the difference. Tax authorities regard this difference as an assumed gain. The alternative minimum tax (AMT)is subject to ISO, whereas NSOs are subject to the income tax system. Working with a tax professional is always recommended.

Tax treatment for startup equity

The first step is understanding the type of equity compensation you’re dealing with, which will impact your tax situation. The following are three common types of equity awards:

• Stock options – Employees with stock options have the right but are not obliged, to purchase shares at a predetermined price over a set period. Stock options are typically divided into two types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs) (NQSOs). When you exercise (purchase) your options, you typically do not owe taxes on them. Still, you must include the exercise price and the FMV difference at exercise in your alternative minimum tax (AMT) calculation for that year. Because there is no AMT calculation, NQSOs are much simpler. The difference between the exercise price & FMV of the stock at the exercise time is taxed as ordinary income for NQSOs. When you sell the shares, you may be subject to additional taxes.
• Restricted Stock Units (RSUs) – Restricted Stock Units (RSUs) are a promise made by your company to deliver shares to you once your RSUs have vested. You will owe ordinary income tax on FMV of the shares delivered to you when your RSUs vest, and your company will most likely withhold applicable taxes at vest/delivery. When you sell the shares, you may be subject to additional taxes.
• Employee Stock Purchase Plans (ESPPs) – Employee Stock Purchase Plans (ESPPs) are an optional benefit that allows you to buy company stock at a discount using after-tax payroll deductions. The time you wait before selling your shares is important, as is the value of your shares when you sell them. If you sell your in over one year after purchasing them or two years past the beginning of the offering period, a portion of the gain over the purchase price may be treated as a long-term capital gain. Long-term capital gains ought to be taxed at a lower rate compared to short-term capital gains, which apply if you sell your shares within a year. Make sure to understand which shares you are selling off, as it has its own tax implication. 

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