Tax Considerations for Incentive-Based Compensation at Your Growing Tech Company

Incentive-based compensation can be a crucial tool for technology companies to attract and retain top talent, especially if you are expanding or looking to grow quickly. However, it comes with significant legal, tax and compliance considerations, and understanding these complexities can be a potential hurdle to designing a compensation plan that not only provides value to employees but is also compliant and tax advantageous. We’ve provided some key tax considerations for incentive-based compensation, including compliance with Section 409A, types of incentive-based compensation, elections required and the Section 1202 capital gains exclusion.

Types of Incentive-Based Compensation

Companies have several options for incentive-based compensation, each with its own unique tax, legal and strategic considerations.

1. 1. Stock Options

Stock options provide employees the right to purchase shares at a predetermined price, known as the exercise price, after a vesting period. There are two main types:

Incentive Stock Options (ISOs): Reserved for employees, ISOs offer favorable tax treatment, such as deferral of income taxes until the shares are sold, and potentially avoiding ordinary income tax if holding requirements are met. These are generally offered by publicly traded companies or private companies planning to go public.
Nonqualified Stock Options (NSOs): These can be granted to employees, contractors and advisors but are subject to ordinary income tax on the difference between the fair market value and exercise price at the time of exercise.

2. Restricted Stock Awards (RSAs)

Restricted stock is granted outright to employees but is subject to vesting and forfeiture conditions. It’s typically used for early-stage founders and key executives.

3. Restricted Stock Units (RSUs)

RSUs are rights to acquire shares at a future date, subject to vesting requirements. They are often used by later-stage companies due to their simplicity and alignment with employee expectations.

Section 409A: Nonqualified Deferred Compensation

Section 409A of the Internal Revenue Code (IRC) governs nonqualified deferred compensation plans and includes provisions that directly impact equity-based compensation. Noncompliance with Section 409A can result in severe penalties, including immediate taxation, additional taxes, potential interest and penalties. Careful structure to compensation plans can help avoid running afoul of these rules, as well as avoid scrutinization from investors as part of their due diligence.

How Does 409A Relate to Equity-Based Compensation?

Equity-based compensation, such as stock options or restricted stock units (RSUs), can fall under 409A if it is not structured properly. For instance:

Nonqualified stock options must have an exercise price equal to or greater than the fair market value (FMV) of the underlying stock on the date of the option grant to avoid 409A compliance issues.
RSUs typically constitute deferred compensation and are subject to 409A unless they meet specific exceptions.
Companies must perform a 409A valuation to determine the FMV of their stock. This valuation should be conducted by a qualified third-party provider to provide a “safe harbor” and reduce the risk of IRS challenges.

Elections Required for Incentive-Based Compensation

The 83(b) Election

The Section 83(b) is a commonly required election in the U.S. tax code, and it allows recipients of  certain unvested incentive compensation to accelerate taxation to the grant date, rather than at vesting. This election is advantageous if the stock’s value is low at the time of grant, as it can result in lower taxable income and potential long-term capital gains treatment upon sale. The 83(b) election must be filed with the IRS within a specific amount of time depending on the type of award received, but if the recipient forfeits the stock, they cannot recover the taxes paid.

Deferral Elections for RSUs

Recipients of RSUs may be able to defer income taxation under certain plans or arrangements if permitted by the employer. These deferrals are often subject to the rules of Section 409A.

ISO vs. NSO Elections

If granted ISOs, employees do not have to make an election to benefit from favorable tax treatment, but they must meet holding period requirements. With NSOs, there are no elections that would change their default tax treatment.

Section 1202: Qualified Small Business Stock (QSBS)

Section 1202 provides a significant tax benefit for founders and investors, allowing for the exclusion of up to 100 percent of capital gains on the sale of qualified small business stock (QSBS), subject to certain conditions. To qualify for QSBS treatment, the following criteria must be met:

• The company must be a domestic C-corporation.
• Acquired by the taxpayer on original issuance from the C-corporation.
• The stock must be held for more than five years.
• The company’s gross assets must not exceed $50 million at the time of stock issuance.
• The company must operate in a qualified trade or business (certain industries, like professional services and finance, are excluded).
• Under Section 1202, there is an exclusion of up to $10 million or 10 times the investor’s basis in the stock from federal capital gains tax, providing a significant financial advantage for founders and early investors.

Windham Brannon Can Help

Incentive-based compensation is a critical component of a company’s overall growth strategy, but it requires careful planning and compliance with complex regulations. Windham Brannon’s Technology and Tax professionals can help you align your company’s goals with a tax strategy that works to minimize risk and enhance benefits for all stakeholders. For questions or to engage with one of our advisors, reach out to Kyle Putman and Andrew Jones.