Navigating Taxes on Employee Stock When a Company IPOs

As a startup founder or employee, going through an initial public offering (IPO) can be a rewarding experience watching your employee equity grow. But with that reward also comes navigating tax implications. 

Taxes on equity compensation such as employee stock options or restricted stock units can be complex when your company goes public. Understanding how your specific type of equity is taxed can help in planning and potentially reducing tax liabilities. Here’s how various equity compensation forms are taxed at an IPO and potential proactive strategies you can take to mitigate tax burdens.

Table of contents:

1. How Equity Taxes are Impacted by Short and Long-Term Capital Gains
2. The Different Ways Equity Compensation Is Taxed at an IPO
3. Understanding the Alternative Minimum Tax for ISOs
4. How an 83(b) Election Can Reduce Taxes
5. IPO FAQs

How equity taxes are impacted by short and long-term capital gains

Before diving into how equity may be taxed during an IPO, we need to review capital gains tax rates. Understanding short-term and long-term capital gains is important when evaluating how your equity will be taxed when your company IPOs. The taxes owed on gains from selling equity shares are largely determined by how long you hold your shares.

• Short-term capital gains: If you hold your equity shares for less than 12 months before selling them, you will generally be taxed at the short-term capital gains rate, which is your ordinary income tax rate. 
• Long-term capital gains: If you hold your equity shares for more than a year before selling them, you will generally be taxed at the long-term capital gains rate. In the U.S., these rates are 0%, 15%, or 20%, depending on your overall taxable income.

As we’ll see below, based on when you acquire your equity shares, the impact of capital gains tax rates can dramatically increase or decrease your tax bill when you go to sell shares post-IPO.

The different ways equity compensation is taxed at an IPO

Different types of equity compensation have different types of tax treatments. Understanding how your specific equity is taxed before and after your company IPOs is crucial to avoid unnecessary tax consequences. In this section, we look at the common types of equity and how they may be taxed in certain situations. 

Restricted Stock Units (RSUs) and Performance Stock Units (PSUs)

You will experience two taxable events if your company grants you RSUs or PSUs. First, RSUs and PSUs are taxed as ordinary income at the time they vest, based on the market value of the shares. This can mean a significant tax bill for employees as companies go public. To avoid paying taxes before a company IPOs, a pre-IPO company may award double trigger RSUs which feature a vesting schedule with two events known as triggers. Double trigger RSU shares aren’t taxable until two events occur: Often a specific time-based vesting schedule (the first trigger) and then fully vested and awarded at a liquidity event like an IPO or exit (the second trigger). 

Second, once vested and you sell your shares, you will incur a capital gain or loss on the sale of stock. If you had a capital gain, you’d be subject to either a short-term or long-term capital gains tax depending on how long you held the stock.

Restricted Stock Awards (RSAs) and Performance Stock Awards (PSAs)

RSAs and PSAs grant employees ownership of stock upfront, subject to vesting conditions. Similar to RSUs, they are taxed as ordinary income upon vesting based on the share value at that time. Making an 83(b) election with RSAs can be beneficial, taxing the shares at grant time rather than at vesting, potentially lowering the tax if the stock appreciates over time.

Employee Stock Purchase Plans (ESPPs)

ESPPs allow employees to purchase company stock at a discount. The tax treatment of ESPPs depends on the holding period after purchase. Selling shares after meeting the qualifying disposition requirements (holding the stock for over a year after purchase and two years after the beginning of the offering period) can lead to more favorable tax treatment, with profits taxed as long-term capital gains instead of ordinary income.

Qualified Small Business Stock (QSBS)

Holding QSBS offers significant tax benefits, including potential exclusion from federal income tax on up to 100% of the capital gains from the sale of the stock. Your stock must meet certain criteria to qualify as QSBS tax benefits including your shares being held for more than five years and your company’s gross assets not valued at more than $50 million before and immediately after the issuance of the stock.. For employees in startups that qualify as a small business, this can lead to substantial tax savings.

Non-qualified Stock Options (NSOs)

NSOs are taxed as ordinary income at the time of exercise, based on the difference between the exercise price and the 409a fair market value of the company shares. To mitigate income taxes, you might consider exercising NSOs in years where that you expect lower overall income 

You’ll also pay taxes on capital gains once you sell your company stock shares. Your capital gains taxes at the time of sale is calculated by taking the difference between your stock sale price and the 409A fair market value at the time of exercise. If you held the shares for over a year before selling them, you’ll reduce your tax bill by paying long-term capital gains. Keep in mind that the value of your stock price can decrease (or increase) the longer you hold your shares.

Incentive Stock Options (ISOs)

While ISOs are not subject to the ordinary income tax rate at the time of exercise, the difference between the strike price of your stock options and 409a fair market value of the stock at exercise is subject to the alternative minimum tax (AMT) in the year you exercise your options. AMT is complex and a tax advisor can guide you through the calculations.

ISOs offer a tax advantage if certain conditions are met, creating what’s called a qualifying disposition. A qualifying disposition occurs when you hold the shares for at least one year after exercise and two years after the option grant date. This creates the benefit of having any profits from the difference between your sale price and exercise price taxed as long-term capital gains, not ordinary income. If you don’t meet the conditions of a qualifying disposition, the profits will be taxed as short-term capital gains.

Understanding the Alternative Minimum Tax for ISOs

ISOs are not taxed as ordinary income, however, upon exercising your ISOs, you may be subject to the alternative minimum tax (AMT) in the year you exercise your options.

It’s important to understand the definition of AMT. According to the Tax Policy Center:

“The individual alternative minimum tax (AMT) operates alongside the regular income tax. It requires some taxpayers to calculate their liability twice—once under the rules for the regular income tax and once under the AMT rules—and then pay the higher amount.”

AMT is determined by what’s called the “bargain element” which is the following calculation:

(409a fair market value of the stock at exercise – exercise price) * total # of ISOs exercised

You owe AMT if:

1. Your bargain element value exceeds the AMT exception amount; or
2. If the tax you owe determined by the AMT calculation is greater than the tax you owe under regular tax circumstances.

AMT is not withheld at the time you exercise, so you will need to plan accordingly to cover the tax bill when you file taxes.

Keep in mind, when you sell your ISO shares, you will also be taxed at either short-term or long-term capital gains. To lessen the burden of AMT since it essentially can cause ISOs to be taxed twice, you may also be able to apply an AMT tax credit in future years. To claim the AMT credit, you cannot owe AMT in that tax year. There are many nuances of AMT depending on your situation which may call for an equity tax advisor to help navigate.  

See our article “Alternative Minimum Tax (AMT): Everything You Need to Know” for a comprehensive overview of AMT.

How an 83(b) Election can reduce taxes

The 83(b) election is a provision of the Internal Revenue Code that allows startup founders or employees with equity compensation to choose to pay income taxes on the fair market value of their shares when granted, rather than when they vest.

If you’re a startup founder or employee, filing an 83(b) election may be an option to help minimize taxes on your equity in two main scenarios:

1. ISOs and NSOs: If you exercise ISOs and NSOs early before your shares are fully vested, an 83(b) election could help minimize any resulting alternative minimum tax (AMT) dependent on your situation.
2. RSAs: If you receive RSAs which are commonly issued at a nominal value such as $0.001, an 83(b) election could help reduce the amount of income tax you pay.

Paying taxes on the fair market value at time of vesting can potentially reduce your ordinary income tax payment if you anticipate an increase in the value of your shares because you avoid paying taxes on the increase in value in future years after granting.

There are many caveats of an 83(b) election which a tax advisor can help walk you through. Also, see our guide for a deep dive into 83(b) elections.

IPO FAQs

What is an IPO?

An IPO, or Initial Public Offering, is the process by which a private company offers shares to the public for the first time, transitioning to a publicly traded company.

What is my strike price (exercise price)?

The strike price, also known as the exercise price, is the fixed price at which an option holder can purchase shares of their company stock.

What is an IPO lock-up period?

An IPO lock-up period is a contractual restriction preventing insiders who already hold company stock, including employees and early investors, from selling their shares for a set period after the company goes public.

What is an IPO blackout period?

An IPO blackout period refers to a time frame around the IPO when the company’s insiders, such as executives and employees, are restricted from buying or selling the company’s stock, typically to avoid any potential conflicts of interest or insider trading allegations.

Find Your Tax Advisor at Harness

If you need help navigating equity tax questions leading up to or after your company IPOs, tax advisors from Harness are here to answer your questions. Whether you have ISOs, NSOs, RSUs, or other forms of equity, Harness can help you with scenario planning to make the best decision for your tax situation. Get started with Harness today.

Tax related services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances.