Why the startup community is starting to panic about tax reform
Businesses across the U.S. are licking their chops over a possible corporate tax cut, but venture capitalists are sounding the alarm over a small change that could have big consequences for employees at startups.
The Senate tax reform bill as currently written would start taxing stock options as they vest. That means employees at startups who receive options as part of their compensation—a common practice in the tech industry—would have to pay tax as soon as the options are earned, rather than when they’re cashed in.
Fred Wilson of Union Square Ventures laid out in a blog post just why that’s a bad idea.
What this would mean is every month, when your equity compensation vests a little bit, you will owe taxes on it even though you can’t do anything with that equity compensation.
You can’t spend it, you can’t save it, you can’t invest it. Because you don’t have it yet.
Taxing equity compensation upon vesting makes no sense.
Wilson wasn’t the only one sounding the alarm.
Plenty of entrepreneurs and investors echoed his sentiments, arguing that such a tax would have a dramatic impact on the U.S. tech sector—possibly even sending investment overseas.
Options tend to be a big part of compensation at startups—and a major reason why employees are willing to take a chance on working at small, failure-prone companies. Options give employees the chance to buy stock, tying employees to the future success of a company. The contracts specify that employees can buy stock in the future at a set price. To “exercise” the options, employees lay out money to buy their allotted shares at the set price.
Taxing those options themselves instead of the profit (or even loss) made when they’re exercised, tech industry folks argued, would basically destroy that system, and make it very hard for young companies to attract high-end talent.
The current version of the Senate Tax Bill is a disaster for startups because it taxes options upon vesting. Startup stock is illiquid and options often not exercised. This “reform” is nonsensical and benefits incumbents over small businesses — opposite of encouraging innovation.
— Bret Taylor (@btaylor) November 13, 2017
I just read Congress’s new tax plan proposes taxing stock options when they vest rather than when they are exercised.
Thank you Congress for proving you don’t know shit about the challenges of building companies and the value of stock options for recruiting and retaining talent.
— Jonah Lupton 🇺🇸 (@JonahLupton) November 13, 2017
Venture capitalists outside the U.S. even weighed in, some with a tongue-in-cheek take that they hoped the tax would go through, leading to tech investment looking elsewhere.
Please go ahead with the proposed plan to tax vested options, US. We, coming from the rest of the world, need all the advantage we can get.
— Cem Sertoglu (@csertoglu) November 13, 2017
There is, however, some confusion over just what exactly is happening, thanks in part to two different bills (Senate and House) that have each gone through a variety of changes. (The House bill initially included the tax on vested options, but it’s evolving in a way that could actually end up solving a major problem with stock options. As it’s currently written, it would provide employees with a five-year deferment on paying tax on exercised options.)
The Senate, meanwhile, has added the five-year deferment, but still includes the tax on vested options. (Whether or not that means they’ll get taxed twice is unclear.)
This is clearly messy. In the interest of attempting to clear it up, let’s try to walk through what a tax on vested options means. Note that unvested options—options that are yet to be earned—are not privy to the tax.
The core issue with taxing options centers on the fact that they do not have tangible value unless exercised. Startups use them to attract employees in lieu of higher salaries, but their value is contingent on the companies either being acquired or going public.
Imagine you’re hired to work at Company X and get 100 options after you’ve worked there for a year, with the deal being that you buy at $1 per share. You don’t actually have those shares. You just have an agreement that you could buy them if you decided you wanted to do so.
Why would you want to buy? Well, maybe your company gets acquired a year later for $2 per share, at which time you decide to buy your shares for $1 per share and then sell them at the acquisition price. You’d make a cool $100, which under the current tax code you’d pay taxes on.
But you might not want to buy them. Options work because they give employees an incentive to stay at their company and receive a bonus if that company does well. If it doesn’t do well, the employee doesn’t theoretically lose anything because they don’t have to exercise their options. It ends up as a lottery ticket that didn’t pay off. The tech industry is littered with stories where not only did options not pay off, but people ended up losing money if they exercised their options too early.
The new bill would tax that lottery ticket regardless of whether it pays off.
Options themselves had not been taxed before because the tax code only applied to capital gains/losses —when a stock you buy goes up in value or you turn a profit from selling a stock at a higher price. In the new plan, if you buy your $1 options and then sell them for $1, you’re getting taxed on that even though you’re not making any money. And if your startup fails or struggles, you’ve paid taxes on options that you’d never exercise.
As Wilson noted, plenty of people never touch their options and don’t decide to exercise them when they leave a company.
I have seen many employees leave companies and not exercise their vested stock options. It happens all of the time.
That should be a clear enough example to the lawmakers that vesting should not be a taxable event.
But, sadly, I don’t think this is really about what makes sense. It is about politics.
What Wilson doesn’t note is that Silicon Valley and the tech industry in general could do very well here. If the Senate follows the House, the tech industry could end up with a best case scenario—options wouldn’t be taxed, and exercised options would be eligible for a five-year tax cushion.
This would help employees at various tech companies like Uber, where employees literally did not have the cash available to pay the tax on stock that had risen in value but was unsellable because the company wasn’t publicly traded, effectively preventing them from exercising their options at all.
There’s probably twists and turns left to go. Spector noted that the tax on options could stay in the Senate bill because it generates much-needed revenue to offset tax cuts in other areas. Both bills will almost inevitably be subject to serious revisions, and even then face a tough time becoming law.
That said, it’s a scary proposition for startups. But just maybe, Trump supporter Peter Thiel can get the president’s ear. Until then, the startup industry will have to hope that the Republican party’s general inability to pass legislation will doom its tax bill—and ensure its options aren’t taxed.