In this exclusive guest series, Timothy R. Damschroder of Bodman PLC, a 2017 Silver Service Provider Member, shares his perspective on current tax laws that hinder emerging growth companies from obtaining capital gains treatment. In this post, he proposes solutions to eliminate barriers associated with equity grants.
Employees of small companies should be allowed to receive equity grants without the current associated tax and financial burdens. It is complex and often expensive for employees to participate in the financial upside of an emerging growth company.
There are some reasons for this, but the two main issues are:
- The tax laws governing employee equity grants (Internal Revenue Code Sections 422 and 409A) are burdensome for small businesses and their employees; and
- The cost for employees or contractors to pay for the equity to obtain capital gains treatment. This cost is incurred even if the company is not successful and there is no ultimate upside realized. Because of this, often employees are reluctant to “invest” in equity in a manner which would afford capital gains treatment.
This complexity requires young, cash-strapped companies to engage a lawyer to counsel them through the quagmire, pay a valuation consultant to value their company or take the risk without one, and have very little chance of obtaining capital gains treatment.
To relieve these burdens, we propose the following potential solutions:
- Allow small companies with less than a certain amount of revenue (say, $5M) to grant equity to employees on a tax-deferred basis (i.e., no tax upon the date of grant); and
- Afford capital gains treatment to any type of equity granted, payable upon a liquidation event or other sale of the equity held by the employee.
These solutions would help by:
- Allowing small companies to continue paying lower base salaries by supplementing the compensation package with potentially valuable company equity;
- Allowing small companies to grant equity without regard to cost at the time of grant (and would allow for larger grants without negative tax consequences); and
- Removing a major barrier to employee equity compensation by deferring the tax bill for employees that have no other means to pay a (potentially large) bill. Further, in the event there is no liquidity event, the employee would not have paid a tax bill on future income that was never realized.
Employees should not be taxed on a value that may never be realized. Instead, tax them if and when a liquidity event occurs.
About Bodman PLC
Bodman law firm is best known for providing sophisticated, creative and practical solutions to some of the region’s most successful companies and wealthiest individuals on a broad range of issues. The firm’s Emerging Companies and Venture Capital practice assists venture capital funds and angel investors who are looking to invest in and partner with promising companies. As business advisors, Bodman attorneys can provide emerging companies with pragmatic, down-to-earth advice that is aimed to place clients in the best position for future success.