From Stock Options to RSUs, Initial Public Offerings (IPOs) are typically momentus occasions for a company and it’s employees, but can often come with a large tax bill
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The below article primarly covers tax implications regarding RSUs (restricted stock units) and ISOs (Incentive stock options) that you, as an employee, might have to take on due to your company going public. Given that NSOs (non qualified stock options) are a lot less common, they are not covered below.
Quick Summary
- As an employee you will not have any taxes due immediately as a result of an IPO. You will, however, owe taxes on your equity when it comes time to file taxes the following year. The total tax bill will depend on what kind of equity you have (ISO vs RSU, or both)
- If your company grants you RSUs, the total amount vested at the time of IPO is classified as supplemental income and is taxed at the regular income tax bracket rate.
- Your company should withhold a portion of your RSUs at the time of IPO, which will help cover a part of or all of your taxes owed.
- You can estimate how much taxes you may be liable for using our IPO / RSU Calculator IPO / RSU Calculator
- If your company grants you ISOs, you may potentially owe Alternative Minimum Tax (AMT), which is a separate tax that you might be unfamiliar with. You can read more about the AMT through our informational articles, or calculate your AMT using our AMT Calculator AMT Calculator
- If you have both types of equity, your taxes will be a blend of both of the above
Let’s start with the basics: How does an IPO even work from an equity/compensation perspective?
When you first accepted your offer, it is likely that you were offered a salary / cash bonus alongside ‘equity’. This equity can be in the form of Restricted Stock Units (RSUs) and Stock Options (ISO and NSO). Typically you’ll receive a set amount in a grant and that grant will vest over a period of time. Vesting is the process by which, in set increments (i.e. monthly, quarterly, per paycheck) a certain amount of the original grant is ‘given to you’. You can receive subsequent grants, often called ‘refreshers’ or ‘top-ups’ that serve as additive equity to keep you incentived to stay at a company for longer.
- In the case of an RSU, vesting means ‘we will give you X amount of our stock every Y timeframe once we go public or get acquired’
- In the case of a stock option, vesting means ‘to give you the option of purchasing X amount of stock (i.e. exercising the option) every Y timeframe, but it will only be worth something once we go public or get acquired’
There is a long and arduous series of steps that a company must take behind the scenes to prepare itself to go public. You will typically see a company transition away from granting additional stock options to RSUs only, and in some cases, new hires will not receive any equity at all as the ‘outstanding shares’ need to be finalized.
In the leadup to an IPO, your company may convey your opening IPO price. This is an important data point as it can help you estimate your taxes, wether you have RSUs or ISOs.
Restricted Stock Option (RSU) Taxes due to an IPO
Let’s start with the Restricted Stock Option (RSU), or the most basic form of equity. It is the simplest to understand because it functions just like your salary, especially from a tax perspective.
Everytime an RSU vests it is essentially your company saying “Here is some cash in the form of a share of our company”. And just like your regular paystub or a bonus, the RSU received is subject to the same Federal and State Income tax as well as tax withholding.
In fact, when you receive your W-2 at the end of the year, the RSUs that vested that year are literally included in Box 1: Wages, tips, other comp. Officially, RSUs are classified as ‘supplemental income’.
What exactly happens when my RSUs vest?
For illustrative purposes, let’s assume you have a grant of 480 RSUs from company ‘Equity R Us’, which vest monthly over 4 years. That means 10 will vest every month.
To start, just as your company sets a default tax withholding on all of your paychecks, the IRS also mandates that employers set a tax withholding on your RSUs. This is where the ‘supplemental income’ comes into play. Currently, employers must withhold at least 22% of your RSUs (and more if you have excess of 1 million in supplemental income).
That means every month, 22% of your 10 shares in ‘Equity R Us’ are actually ‘withheld’ from you for tax purposes. The company will take 22% of your shares, sell them at the Fair Market Value of the stock on the day it vests, and keep them to help you pay taxes. In our example, this leaves you with 7.8 shares of ‘Equity R Us’ which get deposited to the brokerage account that you set up through your employer (i.e. Fidelity, Schwab, etc).
You might be thinking “But how do you get 7.8 shares”? Well nowadays, it is actually quite common that brokerages allow you to buy, sell, and receive partial shares but the default practice by a company is to actually withhold 22% of your RSUs, rounded up to the nearest share, and return the difference in cash as part of your paycheck.
In this example, that means your company would end up selling 3 out of your 10 shares. You would receive 7 shares in your brokerage account, and whatever the cash value is of 0.8 shares as money in a paystub, or withheld entirely.
So what are the tax implications of receiving RSUs?
There are no taxes that you must pay at the time your RSUs vest. The RSU withholding is just a precaution to ensure a portion is actually paid out to the government if you mishandle your own finances. However, as RSUs are basically counted as income, you will be taxed on the fair market value of all your vested RSUs come tax season, at your regular income tax rate. In other words, if you have an effective tax rate over 22%, you will likely owe additional taxes since your company only withheld 22% of your RSUs at the time they vested.
One thing that is often forgotten, however, is that the RSUs you received (the 7 shares in our example) are sitting in a brokerage account as stocks. And just like with all stocks, you may be subject to short or long term capital gains or losses on your RSUs depending on how long you hold them for, when you sell the stocks, and what price the stocks appreciate or depreciate to.
Always consult a financial or tax advisor for more detailed information, but our IPO / RSU Calculator IPO / RSU Calculator actually does a great job estimating taxes at the federal and state level for these situations.
So what’s the big deal with my RSUs at IPO?
Well, up until now we’ve explained what are RSUs and how they are taxed when they vest. This has all been under the assumption that your company is publicly traded and that the RSUs are worth something.
In the case where your company has been private for a long period of time, your RSUs have been ‘vesting’ in the sense that they are yours, but they aren’t worth anything until your company goes public. Why this is a huge potential issue for many employees is that even though the company will still withhold a percentage for your RSUs for tax purposes, many long tenured employees just aren’t expecting the sheer amount of vesting stocks, and thus the large increase in their tax bill.
Imagine a situation where you have been at a private company for 2-3 years, if not more, with RSUs and equity accruing every paycheck, month, or quarter. Then your company IPOs and even though it withholds 22% of the RSUs, due to the sheer amount of stock accrued, your effective tax rate come tax season is 35-40% not including state taxes. For many people, this could mean a tax bill of 100,000+ that they do not have the liquid cash to cover.
So what are you waiting for? Start planning ahead and estimate your potential tax liability with our IPO / RSU Calculator IPO / RSU Calculator!
Incentive Stock Option (ISO) Taxes due to an IPO
ISOs function quite differently than RSUs. When they vest, you do not receive ‘shares’ of a company. Instead you receive the ‘option to purchase a share of a company at a predetermined price, often lower than the current fair market value’.
In the weeks (or months) leading up to an IPO, employees with stock options vested will begin to start exercising their options (i.e. purchasing company stock at the predetermined upon price). This is so that they can ‘start the clock’ on getting more favorable tax rates from a qualifying disposition. You can read about the basics of an Incentive Stock Option here and the difference between a Qualifying and Disqualifying Disposition here.
Unlike RSUs, when you exercise your ISO, and if you do not sell the subsequent stock in the same calendar year, you are not subject to regular income tax. Instead, you are subject to an entirely different tax system, called the Alternative Minimum Tax (AMT). The short summary is that this is a tax system that is calculated every year alongside your ‘regular income taxes’. It plays by a separate set of rules, and you only ever need to pay AMT if it ever exceeds your regular income tax. This rarely ever happens, but one key exception is when you exercise ISOs.
So why does an IPO matter for ISOs?
In large part, it doesn’t. When your ISOs vest, even when your company is private, it is still worth ‘something’. That ‘something’ is the fair market value of a share of the company, which is determined by underwriters and your board of directors. Every once in a while, your company should share documents that detail what the fair market value (FMV) per share is. You’ll use that to calculate applicable taxes while the company is private.
At any time, even while the company is still private, you can choose the exercise your ISOs. In fact, this often can be the financially sound move, as spacing out your ISO exercise reduces the likelihood you pay AMT.
However, there is one key fact to point out here: while the company is private, there is no guarantee that your shares in your company will ever be worth anything ‘real’. You are putting in real money to exercise your options, but your the shares in your company aren’t really worth anything for the most part.
The reason why an IPO is so important to ISOs, and why you typically see a flurry of activity is that now your stock options are worth something. Folks pile in to exercise and buy their shares at a typically lower predetermined price, which usually results in a ‘guaranteed profit’ of sorts.
However, as mentioned, ISOs are just another form of equity. And whether it’s the Alternative Minimum Tax or capital gains tax, it’s always prudent to plan ahead and figure out if you have a potential tax liability. For those with ISOs who are keen to minimize taxes, you should also take advantage of our AMT Calculator AMT Calculator, and specifically the ISO Tax Planner portion