Is Employee Stock Options Tax Treatment Fair? 

April is just around the corner. Apart from the cherry blossoms blooming all over the DC region, this time of year brings with it the oppressive task of filing taxes. Just when the weather is getting really good and the outdoors beckon, the last thing I want to be doing is poring over 1099s and K-1s and trying to figure out whether to take the standard deduction or itemize. 

As in most years, I have procrastinated until the last minute. Clearly, I should have done this when it was freezing outside, but hindsight is 20/20. Instead of writing this article, I should actually be focused on the task at hand, but this is just another welcome form of procrastination!

This tax season is a little different from most other years for our family. My last company, Fugue, was acquired in early 2022. It’s not every year that I have to deal with the tax consequences of a company sale. 

Not that I’m complaining. We were fortunate that the transaction closed before the tech markets started their roller coaster ride and the epidemic of layoffs hit. Had the deal not closed when it did, I’m not sure it ever would have. My friend who retired from Credit Suisse a few months before the bank's meltdown recently reminded me that luck and timing are everything! 

The Tax Treatment of Employee Stock Options is Unfair

Since leaving Fugue, I have been thinking a lot about how startup successes and failures affect investors and employees so differently. That reality is no more evident than in the way gains from a transaction are treated for tax purposes. This has hit home as I’m parsing through the tax bill from the Fugue sale. Our proceeds came both from my stock option grants as a member of the management team as well as from direct investments in the company over the years. The differences are stark.

Tax treatment of equity is one of the areas where the rules of the game are heavily tilted toward investors and against employees. Simply put, investors get capital gains treatment while employees who hold stock options when their companies are sold pay ordinary income taxes on their gains. This can result in a difference in net after-tax proceeds of up to 20 percentage points or more.  Not 20 percent. 20 PERCENTAGE POINTS! 

That means on $100K of stock sale gains, investors might realize $20K or more of additional net cash than employees assuming long-term capital gains treatment. Not only are the tax rates lower, but capital gains are not subject to payroll taxes (like Social Security and Medicare), which can exceed 7 percentage points.

The differences are even greater if investors are able to take advantage of the Section 1202 qualified small business tax exemption, which totally eliminates federal capital gains taxes for shares held longer than 5 years. Not surprisingly, that exemption is not available to option holders.

When you add up the potential that investors pay no federal capital gains nor payroll taxes on their gains, they might save more than 40 percentage points in taxes relative to employees holding options. That's a bit hard to swallow.

Employees can of course get partial or full capital gains treatment by exercising their options and holding them until the time their company sold, assuming it ever is. However, that entails taking on significant risk by committing hard-earned cash that many employees are not in a position to bet on the uncertain success of their startup. In my experience, very few employees in private companies ever exercise their options. That is often a prudent investment choice, but it means they will never get the benefit of capital gains treatment. 

Why Are There Differences in Taxation?

The basic theory of taxation differences is that employee option grants represent compensatory assets. In other words, you earn options from work and they are part of your compensation so are taxed accordingly. By contrast, stock acquired by investors is considered non-compensatory. Investors risk capital, so gains are taxed as any other investment would be, as capital gains. On its face and in the mind of regulators, tax professionals, and accountants, this may seem logical. But is it fair?

There are a number of inconsistencies in the way different forms of equity and gains are treated depending on the situation. Those inconsistencies favor capital over compensation, investors and founders over employees, and investment professionals (e.g. venture capitalists and private equity partners) over everyone else. 

Founders' Common Shares Get Capital Gains Treatment

In a typical startup, the founder(s) start out owning 100 percent of the equity. What they get is common stock, not options. The theory of that stock issuance is that the founders will work to build the company and since the company doesn’t have any cash to pay them in the beginning, they receive their compensation in the form of stock. Technically, they may put up a nominal amount of cash to incorporate the company and "buy" their stock, but everyone understands that the stock is issued not for the pittance of cash they contribute, but as sweat equity.

Unlike employee stock options, gains on founder stock are taxed like any other form of stock held by investors. When the company is sold, earnings on the sale receive capital gains treatment. Even though the stock was ostensibly received in anticipation of services rendered and was by its nature compensatory. It is true founders forgo cash compensation to get their founders' stock, so that is intrinsically a form of investment–giving up salary and getting stock in return. Seams reasonable.

Employees Make an Investment Going to Work Every Day

Founders aren’t the only ones who invest their sweat equity. Employees in startups also make an investment in their companies every day they go to work. One of the trade-offs they often face is taking lower salaries to work at an early-stage company and taking stock options with the hope that those options will be worth something someday. 

So how is that any different from founders? Founders receive stock for sweat equity. Other employees receive options for what is conceptually the same thing. How does it make sense that they are treated so differently from a tax perspective?  

Private Equity Carried Interest is Taxed As Capital Gains

Investors who purchase stock for cash have bought an asset that should receive capital gains treatment. However, in the world of startup finance, the actual money invested by venture capital and private equity firms comes from the limited partners of those firms, not the investment professionals who make those investment decisions. Making those decisions is the “job” of those professionals, for which they are compensated through salary, bonuses, and "carried interest" (the mechanism through which investment professionals share in the gains on those investments). 

If compensation for doing one's job is taxed as work for employees, then shouldn’t that be consistent across both the work of employees AND the work of the investors who invest in their companies? It should, but it's not. Carried interest receives capital gains tax treatment.

One of the proposed clauses stricken from the recently passed Inflation Reduction Act was to tax the carried interest on private investments as income, not capital gains. The argument, as laid out in this piece from CNBC, is that carried interest is actually compensation, not a form of investment, and should be treated as such for tax purposes.

I'm not saying here that investment professionals should be taxes on carried interest as income. I'm merely saying that if investment professionals receive capital gains on their compensation, how is it logical that startup employees holding options don't?

Warrant Holders Get Differential Tax Treatment

One of the quirkier inconsistencies on the equity taxation front is the way warrants are taxed. According to an article by tax attorney Mike Baker, warrants are taxed differently depending on how they were issued. Warrants issued to investors are taxed as capital gains, even it not exercised. Warrants issued to service providers are considered compensatory and taxed as ordinary income.  Same security. Different treatment. How does THAT make sense? 

The Bottom Line

When a startup is sold, founders holding common stock and investors who funded the company get capital gains treatment. Investment professionals in private equity firms also receive capital gains treatment for their carried interest, which is the majority of the compensation for their work. The only people who consistently don’t receive capital gains treatment for their upside from company sales are employees who hold stock options. 

The intrinsic rationale for capital gains treatment is that investors should be incentivized to put their capital at risk and that without favorable tax treatment, their propensity to invest would be diminished. Option-holding employees are subject to the same volatility and risk to their equity-based holdings as any founder, investor, or investment professional. So why shouldn't they be incentivize with the same favorable tax treatment?

The consequences to employees when their companies fail are even more dramatic than they are for investors. Not only do they lose their upside, but they also lose their jobs. So why when a startup, against many long odds, threads the needle and finally succeeds in realizing an exit should its employees be forced to give up nearly half of the proceeds from their options to taxes when other, often much wealthier, players are paying much lower tax rates? 

If we want capable, talented people to risk their livelihoods and commit their careers to build the innovation economy, we owe them nothing less than to provide the same favorable treatment afforded to other actors in the startup ecosystem. Employees should have the same incentive to “invest” their careers in building startups as founders and venture capitalists do. That means treating option gains as capital gains, just like carried interest. What’s good for the goose should be good for the gander.