Equity Incentives: 3 Tax-Related Questions You Should Be Asking

Equity incentives can be a double-edged sword — while they represent the opportunity for significant upside if your company succeeds, they also come with a wide range of tax planning issues. As an executive or employee of a life sciences company, you may have been granted options to buy shares in your company at a pre-determined strike price. While receiving an option grant is not generally a taxable event, exercising options by converting them to shares does have income tax consequences. So, how can you make your equity incentives less taxing?
In this post, we explore three questions you should be asking about the tax consequences of your option grants.

Lowering the Tax Burden on Your Equity Incentives*
Too often, executives and employees take option grants for granted as something they don’t need to think about until an event occurs, but putting off planning can be costly.

Here are three important questions to ask about your equity incentives:

1. What are the tax consequences of exercising your options?
   This depends on the type of options you’ve been issued. Most options are nonqualified stock options (NQSOs). With NQSOs, the spread — the difference between the strike price and the price at the time of exercise — is considered ordinary earned income subject to regular income and payroll taxes. Options may also be categorized as incentive stock options (ISOs). ISOs do not create regular taxable income when they are exercised, but the spread is considered income for Alternative Minimum Tax.
2. Does an 83(b) election make sense for you?
   An 83(b) election is a notice given to the IRS that you would like to be taxed on your options on the date the equity was granted to you, rather than on the date the equity vests. You will have to pay income tax now on the value of the total number of shares granted, but the tax consequences later could be much greater if the value of the company increases. Making an 83(b) election allows you to change the tax treatment on any option gains from ordinary income to long-term capital gains, which are taxed at a much lower rate.

Figure 1. How an 83(b) election works: A hypothetical example
In each scenario below, assume you receive 50,000 shares subject to one year vesting. Each share is worth $0.01 per share at the time of grant, $1.00 per share at the time of vesting, and $5.00 per share when sold more than one year later. Also assume you are subject to the maximum ordinary income tax rate (37% for 2020) and long-term capital gains tax rate (20% for 2020).

Keep in mind that you would need to make this election within 30 days of receiving your options.

3. Would your shares qualify as Qualified Small Business Stock?
As of September 28, 2015, you can sell qualified small business stock (QSBS) and exclude up to $10 million in gains from federal income taxation. QSBS rules are complex and include some key requirements for taking advantage of this exclusion, including:

• Entity type. Only stock in C corporations can qualify for QSBS treatment. Many founders choose to incorporate as S corporations to avoid corporate-level income tax and to take advantage of losses in the early years of the company. Given the substantial benefit of QSBS treatment, it may be worth considering C corporation status from the outset to get the clock ticking on the five-year holding period, especially if the company is not expected to have significant taxable income during that time.
• Type of stock. You must have acquired the stock at original issue or via a gift or bequest from someone who acquired the stock at original issue. The gross assets of the company at the time the stock was acquired must have been less than $50 million.
• Issue date. You must have acquired the stock on or after September 28, 2010. Stock acquired prior to that date is only eligible for a partial exclusion that is subject to the AMT.
• Holding period. You must have held the stock for at least five years. The five-year holding period is for shares — not options — so if QSBS treatment is a future possibility, exercising options early and along the way may make sense. Negotiating an accelerated vesting schedule may also be useful for jumpstarting the five-year holding period.

Planning Now for Your Payoff Later

For life science executives and employees, deciding how to handle option grants can be a complex undertaking. But consider this example: A scientist is hired by a Series A therapeutics company that is valued at <$50 million. Over the next eight years, the company is able to bring two compounds to market, which leads to a successful IPO. The scientist is able to sell $10 million worth of shares and pay less than $80,000 in capital gains taxes.**

Tax efficiencies like these are only possible with thoughtful, proactive planning that considers where your company is in its lifecycle and when a liquidity event is projected. Consider talking to your professional advisors about what tax strategies might make sense for you.

* Strategies are subject to individual goals, objectives, and suitability. Talk to your professional advisors to see if any of these strategies may be suitable for you.
** For illustrative purposes only. This is not a promise or guarantee that tax savings, or any financial results, can or will be achieved. All investments involve the risk of loss, including the risk of loss of the entire investment.