The latest Senate version of the “Tax Cuts and Jobs Act” has a stab in the eye for startups. It proposes to tax certain stock options and RSUs at the time of vesting. An earlier House version also contained this provision, but the House removed it. 

Startups are a key part of innovation. Often joining a startup means accepting a lower cash compensation for a higher potential upside. This upside usually comes in the form of stock options or other stock based compensation such as restricted stock units (RSUs). For these to be effective means of offsetting lower current compensation, they need to provide upside with no downside.

In particular, an employee should not own taxes on the appreciation of the capital until they actually have liquidity in the asset. Everything else runs the risk of having to pay taxes on paper gains that subsequently evaporate. This problematic situation exists today already for many employees who leave companies and have to exercise their options and there have been legal efforts under way to change that.

The Senate version of the bill does the exact opposite. It now moves the tax payment for options to the point of vesting. So imagine working for a highly successful startup. At each vesting date you would owe a tax payment on the difference between your option strike price and the now fair market value. These could be substantial payments! Not only do you not have the money to pay those unless you are already wealthy but also you have no idea what those shares will eventually be worth. It could easily be much less again. Possibly zero! We have seen plenty of companies that had been valued in the 100s of millions and some in the billions of dollars that went to 0 without ever achieving liquidity along the way.

Now it is somewhat unclear whether this would affect all options or only so-called non-qualifying options. If it only affects the latter, then one possible way to fix the issue would be to dramatically increase or entirely remove the cap on the amount of equity that can be awarded in an incentive stock option (it is currently $100,000 which is why many executive grants wind up being non-qualifying).

I don’t know if this tax bill has a chance of passing. I suspect that it does as it appears less controversial than the healthcare bill. If you want startups to continue to be able to readily use deferred equity compensation then I encourage you to call your Senators right away and let them know you are opposed to Section III(H)(1) of the “Tax Cuts and Jobs Act.”