Comprehensive Tax & Compliance Strategies for Startups

Recently, a poll done by the National Small Business Association revealed that about 40% of small firms spend more than 80 hours a year only on taxes and federal tax compliance. It demonstrates the great amount of time and money required for tax compliance.

It can be pretty hard for these companies because they will have to meet the reporting requirement, the compliance obligation and tax regulations, especially if very little resources and expertise are employed.

In such cases, a tax strategy guide can improve cash flow, lessen financial obligations, and encourage long-term expansion. 

Developed with startups in mind, Eqvista’s tax guide and compliance strategies are easy to understand and implement. Our tax compliance, planning, and optimization information helps startup founders and financial leaders make informed decisions that meet growth objectives and regulatory needs.

Tax Implications for Startups

Stock options are an integral part of employee compensation at many startups. The organization and its workers must fully grasp the tax compliance and consequences of those options.

Startups face two primary tax considerations when they grant stock options: ordinary income tax and capital gains tax. Here’s how they work:

When a company grants options, there’s no immediate tax impact for the employee. The value of the option is usually adjusted to reflect the company’s current worth by setting its exercise price at the stock’s fair market value on the date of the grant.

• At exercise – The tax picture changes when an employee exercises their options. At this point, the “spread” or “deal element” – (The current market value minus the exercise price) – becomes taxable. This amount gets treated as ordinary income, reported on the employee’s W-2, and subject to payroll taxes for both the employee and the company.
• At sales – Further tax considerations arise when employees sell their acquired shares. If sold within a year of exercise, the transaction falls under short-term capital gains rules, taxed at ordinary income rates. Holding the shares for over a year qualifies for potentially lower long-term capital gains tax rates.

Proper tax compliance is crucial at both stages.

Tax Forms Companies Must Report to the IRS

• W-2 Form – Employers must report their employee share compensation taxes deducted from their paychecks on Form W2 each year. They use the W2 form to calculate employees’ withheld amounts. The employee must then provide this paperwork to the employer by the IRS deadline. Many people seek the advice of tax experts before filling out their W-2 forms to make sure they’re getting the maximum deductions available.
• Form 1099-B – Sending out Forms 1099-B to both investors and the IRS is the responsibility of brokerage firms or brokers. The form requires them to document the sales of investment products like  mutual funds or stocks as part of their tax compliance requirements. This form will detail the sale price, the tax basis (generally the fair market value at exercise), and whether the gain or loss is short-term or long-term, all of which are crucial for tax compliance.

Employee Stock Option Types & Taxation

Employee Stock Options in a startup come in two forms: Employee Stock Purchase Plans and Incentive Stock Options. 

Both have different tax treatments and advantages and therefore, employers and employees need to know their differences to avoid any tax issues.

Employee Stock Purchase Plans (ESPPs)

An ESPP enables the employees to purchase the company’s stock at below-market prices; this is done through deductions from employee payroll over an offering period set by the plan. The market price can be at an offered discount of about 15% when purchasing.

Let’s consider the tax implications and tax compliance of ESPPs.

There is no tax liability when a discount is claimed at purchase, the plan is qualified according to IRS regulations, and the stocks are not sold instantly.

The sale of shares acquired through an ESPP may be taxed as follows based on the holding period:

• Qualifying disposition – If the employee holds the shares for more than two years after the year of grant and one year after the date of purchase, any profit from the sale of stocks is considered a long-term capital gain. The discount is treated as ordinary income and taxed as such.
• Disqualifying disposition – By contrast, if the shares are sold before the above-listed time, the ordinary rates will apply to all profits.

Form 3922 is issued for each transfer under the ESPP, and it is important to understand if the sale qualifies for favorable tax treatment.

Incentive Stock Options (ISO)

ISO lets employers buy a company’s stocks at a predetermined price normally lower than the market value when the options are granted.

So, let’s consider ISOs’ tax compliance and tax implications in action.

One essential point to remember when exercising ISOs is that there is no tax on practicing making purchases in the corporation if the appropriate shares are the property of the employee. 

But, the variance between the fair market value and the exercise price may give rise to this alternative minimum tax or simply AMT.

If the shares have been held for at least one year after the exercise and two years after the option grant, then all the profit becomes subject to taxes on long-term capital gains at a low tax rate than ordinary income.

Selling these shares before the expiration of the aforementioned holding periods is referred to as a disqualifying disposition, and the gain thereon is treated as ordinary income.

Form 3921 is issued when ISOs are exercised. It details the exercise price, the fair market value, and the date of exercise, which is important in calculating AMT from sale.

What is Form 6251?

The Internal Revenue Service (IRS) has imposed the Alternative Minimum Tax (AMT) on certain income earners who satisfy specific income thresholds but cannot avail of deductions and credits to eliminate/remove or reduce the tax on their income substantially.

As much as the law allows bringing down an individual’s taxable income to zero, the IRS employs the AMT to make sure everyone pays their fair share. Tax practitioners fill out Form 6251 to determine their AMT.

Restricted Stock Units (RSUs) & 83B Election

Companies often use Restricted Stock Units (RSUs), a type of stock remuneration, to reward and retain staff.

RSUs are awarded with a vesting schedule that is usually dependent on continuing employment or achieving performance goals. Upon reaching a preset “vested” status, they are calculated as income according to their fair market value.

Typically, when RSUs vest, their fair market value is taxed as ordinary income. Workers are liable for employment and income taxes on the vested RSU value. The proceeds from the sale of the shares in the future are subject to capital gains tax.

What is the relevance of an 83(b) election in this case?

There is a provision in the US tax law that allows employees to adjust the taxation of their RSUs by electing under Section 83 (b). The effect of making an 83(b) election is that employees can opt to be taxed at their grant rather than vesting. 

When should you consider it?

Since shares are likely to increase in value until the vesting date, the 83(b) election allows employees to make tax payments on lower share values at the grant rather than wait until vesting, when the value may be considerably higher. 

Any further increase in the value of the shares realized upon sale would be subject to capital gains tax, which is less than the income tax rate for most people.

Also, keep in mind:

• Taxes must be paid upfront based on the fair market value at the time of the grant, regardless of whether the shares vest.
• If the employee leaves the company before the shares vest or if the value of the shares decreases, the taxes paid cannot be recovered.

Exemptions and Limits

As a startup, you must know the ins and outs of equity pay, including the limitations and exemptions that might affect your tax compliance and responsibilities. 

Rule 701

Rule 701 is issued by the Securities and Exchange Commission (SEC) and allows private companies to offer equity compensation to employees without registering the securities. This exemption applies only to offers made as part of a written compensation agreement to directors, employees, officers, general partners, trustees, or certain consultants and advisors.

The total value of securities sold in any consecutive 12-month period: 

• Must not exceed $1 million, 
• 15% of all the issuer’s assets or 
• 15% of outstanding class securities being offered.

If the amount of securities offered exceeds a certain threshold (currently $10 million in a 12-month period), the recipients must receive additional disclosures, including financial statements, risk factors, and information about the equity plan.

The ISO $100,000 Limit

ISOs offer employees a tax advantage but come with an annual limit on the value of shares exercised in any calendar year to qualify for special tax treatment. 

The fair value of shares awarded over the period the option is issued cannot be more than $100,000. Any amount over this limit becomes treated as a Non-Qualified Stock Option (NQSO) with different tax implications.

Let’s look at the tax implications of exceeding the ISO limit:

• ISO benefits – For ISOs within the limit, income is not recognized upon exercise of the option, and no regular income tax liability is due until the stock is sold. If the stock is held for more than one year after the exercise date and more than two years after the option was granted, Long-term capital gains tax at lower rates applies to any gain.
• Excess as NQSO – If the $100,000 limit exceeds, the options in excess get treated as NSOs. So, taxation occurs during exercise, with variation in value between the stock’s exercise price and its current market value taxed as ordinary income, subject to income and employment tax withholding.

Accounting Standards

Firms offering employee stock plans must be well-versed in accounting standards to estimate asset values effectively. The two key standards are ASC 820, which lays out procedures for fair value measurement, and ASC 718, which regulates the accounting for employee stock programs.

ASC 718

Companies that want to “expense options” or acknowledge the value transfer associated with giving employees stock options and other equity remuneration follow ASC 718 as standard accounting guidelines. 

It offers guidelines that mandate that all stock-based compensation, including non-employee equity awards and employee equity awards, be reported at fair value in income statements. 

Employee stock-based compensation can be expensed in three simple steps according to ASC 718 guidelines:

• Determine the equity compensation’s fair value.
• Distribute the cost throughout the economic life of the option (more on that later).
• Add the cost of compensation to your income statement.

ASC 820

ASC 820 specifies the steps to take when estimating fair value to ensure accurate financial reporting. It creates a framework for fair value that applies to all US GAAP-compliant fair value calculations. ASC 820 measures fair value by calculating an “exit price” that considers multiple important concepts, and it differs from transaction or entry pricing.

This standard categorizes inputs used in valuation techniques into three levels:

• At level 1, we have observable inputs, like current market prices.
• Level 2 constitutes observable asset or liability inputs other than quoted prices in
• Level 3 constitutes unobservable asset/liability inputs.

QSBS/Section 1202

A qualified small business stock, or QSBS, is a type of stock that a qualified small business issues and receives directly from the business in exchange for cash, other assets (not stock), or as payment for services rendered. 

QSBs can raise as much money as they want. This remains valid, provided that the company’s gross asset value does not exceed the $50 million mark for QSBS.

Section 1202 of the IRC offers significant tax benefits for Qualified Small Business Stock (QSBS). To qualify, you must meet several key requirements:

• Cap on tax savings – The maximum excludable gain is $10 million or ten times the shareholder’s basis, whichever is greater.
• Original issuance – Shares must be acquired directly from a U.S. C corporation after 1993 in exchange for money, property, or services.
• Holding period – Stockholders must hold the shares for at least five years.
• Active business requirement – At least 80% of the company’s assets must be used to conduct one or more qualified trades or businesses.
• Gross asset limit – There can be no more than $50 million in total gross assets of the company either before or immediately after the stock purchase.
• Qualified trade or business – The company must engage in a qualified trade or business, excluding certain service industries, banking, investing, and hospitality.
• C corporation status – The issuing company must be a C corporation throughout the holding period.

Section 1202 encourages non-corporate taxpayers to support small businesses. The fundamental objective of this section of the Internal Revenue Code is to provide a means by which the sale of stock in a small business is exempt from federal income tax. The federal government will not tax any or all of the gain from selling small business stock you have held for five years or more.

Improve your Tax Compliance and Planning with Eqvista!

Startups must handle extensive tax compliance and regulations to grow and survive. When you have all the information you need about tax implications, stock options, and equity awards, you can make smart decisions that help you achieve your goals. 

For long-term success, you must understand tax implications, exemptions like Rule 701, and accounting standards like ASC 718 and ASC 820. Eqvista understands these complexities and provides customized solutions to deal with them. To help startups stay in compliance and maximize their corporate tax strategies, our platform incorporates cap table maintenance, getting a 409A valuations, and equity management.

Talk to our experts now to improve your startup’s tax compliance. Together, we can identify your unique requirements and craft an all-encompassing tax strategy guide to meet your expansion goals while meeting every applicable regulation.