The Biden Administration has reportedly proposed significant changes to the capital gains tax, aiming to target the wealthiest Americans to help fund his historic aid programs.
If the current proposal goes into effect, it will have an impact on startup employees who aren’t (yet) wealthy. And it’s unlikely the Biden Administration has considered the consequences, because many of these employees aren’t yet in the highest tax bracket. But startup employees need to pay close attention to these changes when planning what to do with their stock options.
We don’t yet know what will end up in a passed bill, which may look very different from the originally proposed plan. This shouldn’t cause alarm for employees or cause them to avoid exercising options, but it is something they should be thinking about when planning their equity strategy.
When it comes to employee equity, the worst decision is always not having a plan of action.
As always, employees should work with their advisers to plan accordingly and get ahead of any changes.
How changes in capital gains tax impact startup stock options
Historically, long-term capital gains, or gains on assets held for over a year, have enjoyed preferential tax rates in comparison to short-term capital gains, which are assets held for less than a year. In Biden’s original proposal, he suggests raising the long-term capital gains rate to the highest ordinary income tax rate on income over $1 million.
If Biden’s changes are enacted, it means that there would no longer be preferential tax rates for those that make over $1 million on the sale of their shares post-IPO or as part of an acquisition. Many employees “go long” with their equity, selling them a year after exercising to benefit from long-term capital gains tax. Under this change, they may be limited to the amount of upside they can convert to preferential capital gains tax depending on their income levels and when they sell.
As with any tax legislation, the devil is in the details, many of which are still to be determined. These are the questions employees should be asking if the legislation moves forward:
Is the first $1 million in capital gains still taxed at preferential rates or do I factor in other sources of income to determine the $1 million threshold?
How can I plan around the sale of my shares to stay under the $1 million threshold?
Is there any impact on qualified small business stock (QSBS)?
Clarity on these questions and details of the plan will provide critical information for employees looking to exercise if Biden’s tax plan advances in Congress.
Capital gains tax rules have always been political
Many presidents have expressed interest in changing the capital gains laws in the past. President Obama, for example, wanted to raise the capital gains tax. President Trump campaigned on capital gains rules, suggesting the carried interest rules, which are possible because of capital gains tax rules, be eliminated.
The questions now are: Will Biden be successful in addressing capital gains tax rules? And will the Democrats risk backlash or potential downsides driven by increased capital gains tax? Many experts suggest that the final legislation, if passed, will result in a capital gains tax increase, but much less than Biden’s original proposal. Some are suggesting Congress will settle on no more than 30% as the highest capital gain rates for those who earn more than $1 million.
Only time will tell, but the suggested tax plan may create a significant, if unintended, burden to startup employees more than anyone else.
Planning around your equity
There’s still a lot of uncertainty around what new tax legislation may look like or if it will happen at all. At this point, startup employees may not necessarily need to act on these potential changes, but they should be taking it into account when planning what to do with their equity and, more specifically, when they are planning to exercise.
Either way, employees should still strongly consider exercising their stock options (it’s a key benefit of working at a startup, after all). Taxes are just one consideration. For example, many companies have exercise deadlines after employees leave a company.
Even if rates to capital gains taxes change, exercising early may still have its benefits, as many employees may still be able to create a plan to sell up to a certain number of shares at preferential rates every year.
While Biden’s proposed plan is focused on changing the federal tax rates, state income tax considerations remain. Startup employees have been moving away from high-tax states such as California and New York in favor of no-income tax states such as Texas and Florida. Those that are planning a move may have a big incentive to exercise their options to limit California and New York’s reach on the shares.
It’s important that employees understand the advantages and disadvantages of exercising today versus waiting until after an IPO. When it comes to employee equity, the worst decision is always not having a plan of action.