An issue quietly brewing in a current Senate tax bill that would be harmful to startups is moving quickly. The 2017 Tax Cuts and Jobs Act appears to have a few nuggets worth paying attention to if you focus on options as a part of your compensation package.
The team at Engine—a San Francisco–based nonprofit—raised the issue to a group of peers this morning and said it well:
“In the current bill, options and RSUs would become taxable at the time of vesting, rather than at the time of exercise, potentially putting employees in a bad tax situation on an ongoing basis”
Options in and of themselves can be a bit of a quagmire to understand, so I’m going to do my best to break down why this matters deeply to innovation in this region. Recruiting to the region means having attractive compensation packages and a big part of a startups comp package is through options.
Options are an option to purchase shares in a company. They are attractive in their current form because they don’t require a cash outlay from the employee until the option is exercised.
Let’s look at the impact of this in a few scenarios…
Say you’re in a high growth startup but it doesn’t work out. Public and private companies can go up in value and that’s nothing new. Let’s say you are granted $10K in new options when you are hired. In this new scenario, you’d owe money before you’ve really even made any. Let’s say you rise in the ranks in the business and you get another grant 2 years later, $200K in options. You owe again. Maybe all the growth didn’t work and the company ends up closing down. You’ve spent gobs of money on paying taxes and have nothing to show for it. The options never turned out to be worth anything.
In another scenario, let’s say there is really no growth and it never works. Let’s assume you have a few $10K option grants, a tax obligation and zero positive outcomes. You’re still out thousands of dollars and most early stage startup employees aren’t flush with cash so this isn’t attractive at all.
In the scenario all startups are shooting for, there is a great and successful outcome. Let’s say you get the $10K grant, another $200K grant, and another $500K grant because everything is working so gloriously. Consider your tax obligation on $710K in new income before you ever see a dollar in your bank account… It’s not impossible to imagine a world where people have to start taking out complex loans just to manage their options. It’s also not impossible to imagine that this change could make it so hard for some people to acquire their options that they simply don’t.
We want more people to have positive outcomes and attractive option packages they are likely to exercise. Many individuals who have successful outcomes and great option packages become angel investors in their community. That’s new money in the community to invest.
That’s one of the key parts of the eco-system that keeps it growing.
It’s very easy to see in companies that are offering options, how the employees could start getting a tax bill with their option grant notifications. Dwolla uses Carta so reminders that your options have vested show up in everyone’s inbox as the options vest. Which—unlike a paycheck stub that shows your tax obligation—there is no actual cash that goes into your bank account. A notice of what you owe with no actual cash to pay for it doesn’t sound like a fun thing to communicate to startup teams.
While this may be less of an issue for a subset of incredibly well-funded companies who can afford to pay that cost for their employees, that doesn’t classify any group of startups I know in the midwest. The entire region is doing so much to make it extremely attractive to build businesses here, letting this pass would be a step backwards in a number of ways.
Here is the letter from Engine:
We are a group of startups, investors, and innovators deeply concerned about the proposed changes to the taxation of non-qualified deferred compensation plans in Section III(H)(1) of the Tax Cuts and Jobs Act. This shift would have profound negative consequences for technology start-ups by, among other things, undermining their ability to compete with large incumbents for employees.
Section III(H)(1) would require both tax assessment and payment on stock options and other stock-based incentive compensation upon vesting instead of exercise, distribution, or any other liquidity event. The current law, embodied in Section 409A of the Tax Code, enshrines the common-sense notion that employees should pay taxes on income that they actually receive. By making the mere vesting of a stock option a taxable event, an employee would have to pay a tax based upon a hypothetical gain that could take years to become liquid and may never materialize into cash. This would transform stock-based incentive programs from benefits to liabilities overnight and would effectively bar startups from offering this form of compensation.
We cannot overemphasize how essential stock-based compensation is to a startup’s ability to recruit and retain talent. Startups do not have the ability to compete with larger firms based upon cash compensation. A startup’s ability to issue stock options levels the playing field by giving potential employees something unique: the ability to share in the company’s rewards as well as its risks and participate in the upside of a new and exciting venture. This is not just limited to the startup’s top managers: according to one study, nearly 75 percent of venture-backed startups provide options to all employees. In addition, startups are themselves commonly founded by 3 people using the proceeds of stock options that they received at previous startups. Stock-based compensation fuels the growth of existing startups and spurs the creation of new companies.
The changes proposed by Section III(H)(1) would take stock options off the table for startups, which lack the resources to establish and maintain qualified plans or provide employees with increased cash compensation. This will put startups—which are responsible for all net new job growth— at an insurmountable disadvantage. This will reduce competition, innovation, and job opportunities. Section III(H)(1) therefore undermines the stated purpose of tax reform by reducing job creation.
The House of Representatives wisely chose to eliminate this proposal from the House bill. We respectfully request that you remove from Section III(H)(1) from the Senate bill and otherwise decline to change the rules concerning the taxability of non-qualified deferred compensation plans. As written, Section III(H)(1) would cripple startups’ ability to recruit the talent needed to innovate.
My opinion is just one, but if you or your team(s) value options, I’d recommend reaching out to your state senator. I’ve sent a few notes this morning and hope you do the same.
There are issues that are just as complex and no shortage of reading on the topic.
Ben Milne is the founder of Dwolla and cofounder of ClayandMilk.com.