The Tax Law that is (Unintentionally) Hammering Silicon Valley Employees

There have been a number of articles written recently about the anomalous situation of Silicon Valley employees who have worked for years at early stage companies and helped those companies become very valuable, and as a result the employees built significant value in their options, yet those employees are sometimes unable to exercise the options when they leave the company, because they can not afford the required cash outlay.

There are two reasons for the cash outlay required by employees. One is that the option itself must be exercised, so the employee must pay his or her employer the exercise price for the shares being purchased. Although this amount could be significant, for many early employees at a company their option exercise price is often relatively low, so that the total amount required to exercise the option may be a manageable amount.

However, if the company’s value has increased significantly, the real problem for the employee may not be the option exercise amount, but rather the tax on the difference between the exercise price and the current fair market value of the company’s stock subject to the option (the “spread”).

This has always been an issue with “non qualified stock options” where the entire spread is treated as ordinary income and taxed to the employee upon exercise of the option. This is despite the fact that the employee has not sold the stock, and often can not sell the stock because the company is not public and there isn’t a market for the stock. This results in the employee owing tax on phantom income and often having no cash to pay the tax.

This problem was supposed to be addressed by allowing companies to grant employees “incentive stock options” (ISOs) which had the significant benefit that tax was not due on exercise of the option, but rather was deferred until the employee actually sold the stock and had the cash to pay the tax.

However in 1982 Congress made the gain on exercise of an incentive stock option an item of tax preference for purposes of the alternative minimum tax. As a result the gain on exercise of even incentive stock options was taxed, despite the employee having not sold the stock or even having the ability to sell the stock. The effect of this tax is becoming increasingly problematic as companies are building larger valuations, resulting in larger amounts of phantom income and tax to the employee upon exercise of their option, and companies are staying private longer, delaying the ability of employees to obtain liquidity for their shares to be able to pay the tax.

An example of this problem is as follows:

An employee joins a company relatively early and receives an ISO to purchase 100,000 shares at $0.10 per share vesting over 4 years, and is paid $125,000 a year in salary. The employee works at the company for 4 years, the company does very well, and although still private, the estimated value of the company’s stock at the end of the 4 years is $5.00/share, giving the employee a paper gain of $490,000. For personal reasons the employee needs to leave the company after 4 years, and of course wants to exercise his/her option to have the ability to benefit from the company’s success if and when the stock becomes liquid.

The employee has saved sufficient money to pay the $10,000 exercise price on the option. However, the $490,000 spread is included in AMT in the year of exercise, so the employee owes the IRS approximately $130,000, and the California tax is an additional approximately $30,000. The employee does not have the over $160,000 of taxes that he/she will owe to the IRS due to exercise of the options.

The result is that increasing numbers of employees are finding it difficult to exercise their options when they leave their employers (whether voluntarily or involuntarily), due to a tax provision that penalizes them for exercising options in highly successful companies that they have helped build.

In the past, when companies went public quickly before they built huge values, it may not have caused much problem to include the ISO spread as a tax preference item. However, as the entrepreneurial environment has changed, this provision of the tax law has not been changed, and as a result it is reducing employee mobility, employee ownership in the companies they have helped build, and entrepreneurial activity, all social policy objectives that the tax code and other laws try to facilitate.

This tax provision is unlikely to be a significant revenue generator for the government, in part because taxpayers under some circumstances can get a credit for the AMT tax payment in future years, but is causing problems for the Silicon Valley employees building the industries of the future.

Congress should fix this unintended problem.

The views stated herein are those of the author only. Nothing herein should be construed as legal advice, nor create an attorney/client relationship.