The House tax reform bill, as released on November 2, proposed changes to the taxation of stock options that would result in them no longer being a tax-efficient compensation tool for companies and employees, without a demonstrated corresponding tax revenue benefit for the Treasury. Specifically, it provides that all stock options (including incentive stock options or “ISOs” and qualified ESPP options) and restricted stock units (“RSUs”) would be taxable when they vest (even if not yet exercised or settled) , unless exercised or settled by March 15 of the year after the year in which they vest. Currently, options are taxable at exercise.
Subsequent releases have indicated that there may be two exceptions to this proposed rule. First, a summary of the House tax reform bill released by the Joint Committee on Taxation on November 3 indicated that the bill would include an exception for ISOs and qualified ESPP options. Such a provision would provide limited relief due to limits on the value of ISOs and ESPP options that can be granted to employees (e.g., only up to $100,000 of ISOs can vest in any year).
Second, Representative Brady’s amendment to the “chairman’s mark” of the bill released on November 6 provides an exception to the proposed rule for stock options and RSUs granted by private companies, if the requirements summarized below are met. This provision is intended to allow employees of private companies, which do not have a public market for their stock and whose shares therefore cannot be readily sold by employees to cover the taxes arising on their options and RSUs, to delay the tax event for up to five years after the options are exercised or the RSUs are settled. The provision is similar to a bipartisan bill introduced in both houses of Congress in 2016 (entitled the Empowering Employees through Stock Ownership Act), which was supported by NASDAQ Private Markets.
Brady’s amendment allows employees who receive stock on exercise of a stock option or settlement of an RSU to elect, within 30 days after exercise or settlement, to defer the income tax event until five years after such date or, if earlier, the date on which any of the following occur:
- the stock becomes transferable (including to the company);
- the stock becomes publicly traded on an established securities market (e.g., in an IPO);
- the employee is no longer eligible for the deferral, as described below; or
- the employee revokes the deferral election.
The amount of income recognized at the end of the deferral period is based on the value of stock on the exercise or settlement date, even if the value declines (or increases) during the deferral period.
To be eligible for the deferral, the employee must be a full-time employee who:
- is not and has never been the company’s CEO or CFO (or a related person);
- has not been one of the company’s 4 highest-compensated officers in any of the 10 preceding taxable years; and
- has not been a 1% owner of the company at any time in the 10 preceding calendar years;
The following additional requirements (among others) must be met to qualify for the deferral:
- the company must never have had its stock readily tradeable on an established securities market (i.e., it cannot be a successor entity to a previously public company);
- the company must have a written plan under which, in the applicable year, at least 80% of the company’s U.S. employees received options or RSUs with the same rights and privileges;
- the employee may not have the right to sell the stock to, or otherwise receive cash from, the company when the options or RSUs vest; and
- the company may not have repurchased any of its outstanding stock in the preceding year, unless at least 25% of the dollar amount of such repurchased stock was previously deferred by employees under this provision.
On or prior to the vesting date of an option or RSU, the company must notify the employee of the deferral election opportunity. Companies that fail to provide this notice are subject to a fine of $100 per missed notice, subject to a cap of $50,000 per year.
These provisions apply to stock options that are exercised, and RSUs that are settled, after December 31, 2017, and outstanding options and RSUs that satisfy the various requirements are presumably be eligible for this treatment.
It is not clear how these provisions relate to the other compensation provisions in the House tax reform bill. For example, the deadline for an employee’s election to receive this tax treatment is 30 days after the option or RSU vests, but the proposed deferred compensation rules subject the award to tax before that deadline (i.e., on the vesting date).