Equity-based compensation is an extremely common element of compensation packages among start-up companies. Using equity in the company to attract and retain highly skilled employees is an excellent compensation strategy for an early-stage company, and equity is often an expectation for early-stage employees.
If the company has any plans, or even dreams, to eventually expand into the USA it is important to learn about the differences of how equity-based compensation works in the USA. Failure to understand the USA rules for equity-based compensation can result in costly and unpleasant surprises.
Stock options are part of the normal employee compensation package for many start-ups, especially technology-related companies. As the business grows and expands into the USA, employers often wish to utilize similar compensation structures for USA employees. While this makes sense in terms of consistent treatment of team members, there is one key difference to understand before finalizing the USA employee stock option plan. In the USA, the exercise (or “strike”) price for the options must be determined based on fair market value (“FMV”). If the options are issued below FMV, the employee could wind up with a significant tax bill.
Because of differences in methodologies to determine the FMV of stock options between the UK and USA, an appropriate UK exercise price is often lower than an appropriate USA exercise price. If the company were to use the UK exercise price for a new USA employee, it is likely that the options will be issued below FMV (“in the money”) from a USA standpoint. As a result, it is likely that the employee would face additional tax, interest, and penalties. In the USA, the best practice is to engage a qualified third-party business valuation professional to assess the stock option plan and arrive at an appropriate FMV for the stock option exercise price. This valuation is commonly referred to as a (Internal Revenue Code) “409A” valuation. It is not uncommon for many UK companies to be taken by surprise when the need for a 409A valuation first comes to their attention while planning to extend the company’s stock option plan to their USA employees.
Restricted shares are also a common compensation tool for companies that are in an early growth stage. Restricted shares are commonly accompanied by a vesting schedule that allows an employee to earn the shares over a period of time. Complexity arises if the employee moves to the USA before the vesting period is completed.
Under USA tax rules, an employee is required to recognize as taxable compensation the value of the shares that vest at each milestone. For many growing companies, the value of the restricted shares can increase rapidly during the vesting period, possibly resulting in substantial income and related tax liability over the vesting period for the employee.
A common planning tool in the USA is for the employee to consider making an (Internal Revenue Code Section) “83(b)” election immediately upon award of the restricted and unvested shares. By making an 83(b) election, the employee accelerates the vesting to the time of receipt (immediately) and recognizing the current value of all the restricted shares as taxable income at that time. This is usually done in situations where the initial value of the restricted shares is either zero or very low as is common for many early-stage growth companies. The 83(b) election generally results in very low (or zero) tax at inception and also allows the employee to treat the future (hopefully) gain on sale of the stock as capital gain as opposed to ordinary income.
In order to make an 83(b) election, the employee must file the election with the USA tax authorities and provide a copy to the employer within 30 days of being awarded the restricted shares. At the time many young UK businesses are issuing restricted shares, there may not be an expectation of a move into the USA. But if there is a possibility of a future move into the USA, the company may want to suggest the employee consider an 83(b) election in the event of a future move.
The process of filing an 83(b) election with the USA tax authorities for individuals who are not yet USA taxpayers is somewhat complex and outside the scope of this article. Please consult your tax advisor in advance in order to understand this process.
If your plans, even quite far down the road, may include expansion to the USA, you should obtain advice from knowledgeable advisors to ensure neither your company nor your staff discovers they are subject to an unexpected tax bill. The tax advisors at Frazier & Deeter can help you manage your USA expansion to avoid unnecessary surprises.
Authors: Mike Whitacre is a tax partner with Frazier & Deeter, a Top 50 US Accounting & Advisory firm. Brian Holloway is a valuations principal with Frazier & Deeter, a Top 50 US Accounting & Advisory firm. Jonathan Clark is a tax director with Frazier & Deeter UK.