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Tax Reform: A Silicon Valley Perspective
What Congress should do
When an employee of a privately held technology company leaves the company and exercises her stock options, she typically has 3 months to qualify for favorable tax treatment. However, if there has been a run up in the value of the company since the options were originally granted, the employee may face enormous tax obligations. Since secondary markets for shares in privately held companies are often difficult to access, company common stock may only be valuable “on paper,” but the departing employee must pay the taxes on her options in real cash. As a result, many Silicon Valley engineers face “golden handcuffs” scenarios, where they literally cannot afford to leave their companies without surrendering their stock options and sacrificing large fractions of their net worth.
Suppose that as an employee of a large privately held tech company you were granted stock options for 200,000 shares of stock at a strike price of 10¢ per share, and suppose that your stock has appreciated to $3 per share. You’re ready to leave your company and want to exercise your options. You want to pay the $20,000 necessary to purchase your shares at their original strike price and realize a paper gain of $580,000, but at the typical marginal tax rate in California, you must also pay $200,000 or more in taxes. Since you don’t have $200,000 in cash lying around, you reluctantly accept that you won’t be able to leave your company without forfeiting a lot of your compensation – and thus your prospects for taking a sabbatical, buying a house, starting a family, etc.
Today it is common for Silicon Valley companies to remain privately held even with valuations well above $1B. “Unicorns” such as Uber, AirBnB, SpaceX, and Palantir may remain privately held for indefinitely long periods of time. The current tax environment not only makes it difficult for tech employees to realize the fair value of their labor, it also makes it prohibitively difficult to bootstrap new ventures or move to companies where they can follow their passions and deliver superior performance. Current tax laws are stunting innovation and hurting American technologists.
Fortunately, lawmakers are aware of the problem. Congressman Kevin Brady (R-TX) recently proposed an amendment to the GOP tax bill released in the House last week which would indefinitely defer taxes due on the exercise of the most common kinds of stock options – “incentive stock options” (ISOs) and “restricted stock units” (RSUs) – until their owner ultimately decides to sell their stock. The amendment would allow employees who exercise a rarer form of stock option – “non-qualified stock options” (NSOs) – to defer their taxes for 5 years, or, if earlier, until their company IPOs or changes hands. This reform is a welcome improvement over current law.
An even better option is for Congress to amend the Tax Cuts and Jobs Act to allow employees to indefinitely defer taxes on any kind of stock option they have exercised until they sell their shares to another party. On Congressman Brady’s proposal, employees who exercise their NSOs would still be liable for large tax burdens after the 5-year deferral period elapses. Many employees will correctly realize that if they can’t afford to pay the taxes now, they may not be able to pay them later. For a software engineer with a family, risking a $260,000 tax burden is often financially irresponsible, which means that the engineer must accept a somewhat ameliorated version of the classic golden handcuffs scenario. Taxing the sale of stock rather than the exercise of stock options would solve this problem for ISOs, RSUs, and NSOs alike.
Our proposed reform allows employees to exercise their options without risking massive taxes on phantom money that they never actually possess, and boosts innovation by freeing top talent to move freely between companies and allocate time as they see fit. It is a natural extension of the spirit of Congressman Brady’s plan.
Golden handcuffs distort incentives and prevent technologists from freely deploying their talents on projects they are passionate about. Universally deferring taxes until an employee sells their stock will loosen golden handcuffs, tax individuals at rates which reflect their true (not notional) income, and stimulate increased mobility and innovation in the technology sector. We hope that the Ways and Means Committee will seriously consider the proposal.