Having just witnessed the largest IPO in history (http://techcrunch.com/2014/09/22/its-official-alibaba-is-the-biggest-ipo-ever/) and as the number of successful tech IPO’s continues to grow, there are still a significant number of tech companies that haven’t made the leap. Alibaba is the most recent, but the laundry list of rumored companies is an ever-expanding list. Many are almost certainly going public in the next 1-3 years and in each case, there are a large number of executives and employees that will become very wealthy in the process.
Often times, we are called upon to help people with equity awards after an IPO and there is certainly a lot of planning that is required to reduce the tax cost even after the shares are publicly traded. How and when do I exercise options? How and when do I sell shares? How do I use other income/deductions to offset the tax cost of my equity compensation? These are just a few questions of the many that are asked and should be considered.
The fact of the matter is that this may be your one chance to get it right. Decisions made during these types of wealth events are potentially 7-figure decisions; decisions that will affect your future lifestyle, your legacy and when you can retire (among many other things).
Yet despite all of that, most people don’t actually think about planning until the company has gone public. This could be a very costly mistake.
Let’s review a recent case we worked on:
Our client joined the company in 2006, only 2 years after the company was founded. Based on his role, he was awarded 100,000 incentive stock options at $.10 per share as part of his initial compensation package. As time went on, he received several more grants and held close to 1 million options. For several years, he did nothing because he didn’t think the options were worth anything. The Company continued to grow and the 409(a) valuation starting ticking upward. See our article here on Section 409(a). As the valuation increased the tax cost of exercising the options continued to get more expensive. The reason why is because the difference between the option price ($.10 in our example) and the FMV (fair market value as defined by the 409a valuation) is added to income for AMT purposes.
If 100,000 options are exercised at $.10 and the FMV is $1 the add-back is $90,000. (Worst case scenario it would cost $25,200 in taxes but likely less with other offsets). If the stock rose to $50 after an IPO, all of the gain is taxed as long-term capital gain if the stock is held for greater than 12 months from exercise date and 24 months from grant date. So the potential tax on 100,000 shares is between $1.1 million and $1.2 million in Federal taxes (approximate rate of 23.8% between LTCG and additional high-income earner taxes).
If those same options were never exercised and were then exercised and sold at $50 per share after the IPO, all of the income would be ordinary and the potential tax is between $2.1 million and 2.2 million.
As you can see, some strategic tax planning done before the IPO can result in substantial tax savings. In our example above, proactive planning led to about $1 million in true tax savings. The bottom-line is this: If you hold equity in a company that is pre-IPO and you haven’t planned, you may be making a costly mistake.
We would welcome the opportunity to discuss your situation and help you navigate through your questions. We are also developing a software platform to aid in this process that we are calling Vestboard and would love to get your feedback during development.
Any tax advice contained in this message is subject to the following limitations: Nothing herein is intended to convey an expression of an opinion as to the likelihood a tax position would ultimately prevail if challenged by the IRS. This advice was not written nor can it be used by the person to whom it is addressed (or anyone else) for protection from penalties that might be imposed by the IRS. This advice is intended solely for the person to whom it is addressed; no one else should rely on the tax advice provided herein. The person to whom this advice is addressed is under no obligation to keep the advice or matters related to the advice confidential.