Nice to see tax laws for the rich can get passed, but substantive change to do with criminal justice, healthcare etc go nowhere.
The problem this bill targets is the "exercise tax" interaction. Say you are an employee at a start up. Said start up can't afford your full normal salary so they pay you something less but offer you the OPTION of PURCHASING stock in their privately held corporation at a fixed rate (stock options) and often at a "discount" (more on this below).
So a private "board" (of the company) meets and arbitrarily assigns a dollar value to the shares of their company...again this is more or less arbitrary since all stock is privately held so there is no market interaction for price setting. Based on this dollar value, they offer you, the employee, a "discount". So if your board sets a price estimate of $1.50 per share, they might put in your stock option agreement a fixed price of $1.20 per share for X number of shares.
But this means, at least according to tax law, that when you purchase the stock at $1.20, you, the employee, have an IMMEDIATE realized gain of $0.30 per share...lucky you! So this is of course taxable.
Problem being that the current share "value" and the corresponding discount was arbitrarily assigned and actually...you spent $1.20 on a share of a company that has no resale value. So not only do you "buy" (or "invest") into ownership of your start up...you then get taxed on top of it for a "realized gain" that actually doesn't exist. So it's not like you can turn around and sell some of your new "stock" to be able to pay the tax...
1) The board doesn't set the price arbitrarily. They engage a 3rd party accounting firm to do a 409A evaluation of the company. The 3rd party essentially sets the price. It's true that determining a market price for private company stock is just as much art as science but it's not completely arbitrary.
2) The company ABSOLUTELY CANNOT offer stock options at a discount to the 409A. There is a good chance people would go to jail these days if they did that.
3) The discount that you are talking about is the discount from preferred stock (which investors generally hold) and common stock (which employees generally hold). Preferred stock is legitimately more valuable because of various privileges attached to it that are not attached to common.
4) If you immediately exercise your stock upon granting you won't face an "exercise tax" interaction because the price at which you exercise will be the same as your strike price. If you can afford it this, is often a good idea. You have to file some paperwork with the IRS called an 83B to do this right.
5) It's when you wait some period of time that you can face an exercise tax. This is because over time the company will do additional 409As and if the company is succeeding those will indicate that common stock has risen in value. It's that difference that you might have to pay taxes on. It's this tax that this bill aims to let you defer.
Absolutely false. A company can create an option, a warrant, etc. with whatever kind of terms it likes, so long as the board approves and it's permitted by the applicable state law and charter.
The only thing a 409(a) valuation does is provide a "safe harbor" for the company and the employee, that allows them both to rely on the valuation as fair market value for tax & accounting purposes (for the company, so that it doesn't need to expense the option; for the employee, so that there's not an immediate taxable gain upon vesting).
The board, in fact, can make its own determination of fair market value without a 409(a) valuation. But if they do that, they blow their safe harbor and the burden of proof is on them if the IRS comes knocking. So no competent counsel is going to let you go around making up your own FMV.
Finally, I'm pretty sure that a board could even issue options that didn't even pretend to be at FMV, but were at some unconstrained number. There's very good reason, for example, to issue out-of-the-money options when you want people to have skin in the game. There's probably some conceivable reason to issue an in-the-money option, too. (If you do this, though, you are likely condemning both your company and your optionee to a pretty dark slog through the thickets of tax law.)
It is true that there were some criminal (and civil) sanctions tossed around for options shenanigans in the dot com 1.0 days, but they were mainly due to public companies blatantly back-dating options to specific days when the stock price was down, so as to provide guaranteed value to options recipients, without the company needing properly to account for the expense.
Anyway, my only elaboration on point 4 and 5 is that most options agreements have vesting ~~terms~~ schedules (and they typically include 1-year cliffs). So even under ideal conditions you will have to wait a certain amount of time before exercising.
But thanks for taking the time to add additional details!
Your scenario of an immediate $.30 tax liability because of an arbitrary discount also isn't correct. 409A is recalculated on some interval (quarterly generally) and those price changes determine your stock's new value and subsequent tax liability, but only when you exercise options/sell shares.
The common stock discount you're referring to is when there are preferred shares granted to an investor, but common is still determined by an external firm.
Edit: harryh beat me because I type too slowly.
Cheers!
To be fair, I oversimplified when I said "arbitrary"...company valuation estimates aren't _completely_ random...they just aren't set by free market interactions.
This is good for employees NOT for employers.
The current/old method coul create severe Problems for the employee:
People working for an extreme very successfull Startups like Google, Facebook and the like, could become very rich on paper.
Imagine an income of 200 Thousand and quite suddenly 2 Million in Stocks. Now they had to pay taxes on the 2 Million from their normal income, since they couldn't or didn't want to sell their stock Options yet.
200k income 400k taxes? Yes you're fucked.
Ideally, this means more employees can actually act on their options, instead of just "the rich" as you imply.
Ultimately this bill makes working at a startup more attractive when they are already a pretty poor choice, so we'll just have more people making poor choices and putting themselves at financial risk to the benefit of their employer.
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I'm Bob, I write a check for $50K to exercise my stock options. They might be worth something some day, I'm taking that risk and working my ass off to see that they are.
The year I exercise the options, the gov sees that I've made a $1.5M "paper gain", and they want their taxes. Call it $300K.
If Bob doesn't have $350K in the bank, he is stuck - he basically needs to wait until said company goes public to make a zero-cash sale, or forfeit his options when leaving (either by quitting or getting fired).
Not to mention if Bob exercised the stock and payed the $350K - the company could never IPO, or it could and tank. Bob wouldn't see any of that money back.
Bob's upside for working at said risky startup is severally limited.
This is a surprise to most employees, who accepted the risk and assumed they would be able to participate in the upside of the startup (kind of the whole point). These employees find out that, in many cases, they can't actually become shareholders, or they do and lose everything.
In concept, this bill would have Bob write the $50K check for the options, and then only pay taxes once and if actual liquid gains were realized.
How does this only affect the rich or somehow incorrectly incentive people to work for startups?
I'm happy for Bob.
How often do you think gains are ever realized by startup employees given stock options?
But making it costlier to participate only makes the proposition riskier or fiscally unfeisable.
That hurts employees.
Startups are useful in that they trade off innovation for risk - a handful of startups make huge impacts and grow into successful companies.
People know that when they sign up to work for a startup - finding out they can't realize the upside potential is the surprise.
So an alternative way of looking at it is that this bill removes an _accidental_ disincentive for innovation.