In my last post, I talked about how source taxation could mean that you end up paying US taxes long after you move away from the US, or state taxes within the US long after you move away from that state. I didn’t talk at all about how those taxes would be calculated though, and we’ll need to understand that to talk about the more complex problems that arise when you move. Let’s run through how the US taxes equity.
First though, we need to understand the structure of the US tax system. For a host of historical and political reasons, the US levies taxes at three levels: local, state, and federal. In the Bay Area, local taxes are paid by employers, so you only need to worry about Californian and US federal taxes.
Within those systems, there are three different types of equity that are commonly granted by tech companies: Restricted Stock Units (RSUs), Non-Qualified Stock Options (NSOs), and Incentive Stock Options (ISOs). We’ll talk about each of these, and their combinations, in turn. Note that it is also possible to be given Restricted Stock (rather than Restricted Stock Units), but that this is relatively uncommon in the tech industry, so it isn’t covered here.
As a pretty standard disclaimer, although my partner and I have paid taxes in the US, we’ve only had to do so for a few years. Everything I say is based on personal not professional experience. If any of this sounds wrong to you, please reach out and I’ll update it!
🇺🇸Federal US taxes: Restricted Stock Units (RSUs)
Let’s start with the simple case, and imagine that your company grants you RSUs as part of your employment package. This means that your company is granting you stock, typically at no cost, but is doing so in the future: you don’t realize a tax burden until the RSU vests, and when it does, you’re given stock in exchange. Typically this happens in a series of tranches, so you’ll see multiple vests over the life of a grant. When each of these vests happens, the company is giving you something of value for (usually) no cost, so you pay regular income taxes on that value. If you later sell that stock, you’ll pay capital gains tax on the amount that its value has changed since it vested (and you last paid tax). This will be short term capital gains tax (i.e. income tax) if you’ve held the stock for less than 12 months, or long-term capital gains tax (i.e. capital gains tax) if you’ve held it for at least that long.
The US income tax and capital gains tax systems are progressive, with the income tax brackets being between 10% and 37%, and the capital gains brackets being between 0% and 20%. For simplicity, we’ll talk only about the highest of these in our analysis, though your actual tax rates will be lower.
All that yields the following tax statuses for RSUs, federally:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | Income tax | Value of stock at vest | 37% |
| Sale (< 12 months) | Income tax | Gains on stock since vest | 37% |
| Sale (>= 12 months) | Capital gains tax | Gains on stock since vest | 20% |
Note that vesting isn’t necessarily just time-bounded, it can be based on a variety of other factors, as defined in the grant. One common practice for private tech companies is to grant “double-trigger” RSUs: these have both a time-based vesting component, and also a further clause, typically around the availability of liquidity for the stock. You haven’t vested the stock for tax purposes, and so don’t owe tax, until all conditions of the grant have been met. (This prevents you from having a tax burden prior to being able to sell the actual shares, and therefore pay said burden).
In addition to income and capital gains taxes, the US has other federal taxes that apply to these types of earnings:
- income is also subject to FICA tax (i.e. Social Security and Medicare taxes), which is a regressive tax of 6.75% diminishing to 1.45%, and then returning to 2.35%. We’ll use 2.35% for our calculations, since the 6.75% ends up being a flat amount above a certain income threshold.
- capital gains, both short- and long-term, are also subject to NIIT (Net Investment Income Tax), which is a 3.8% tax on investment gains.
That means the actual tax status looks more like this:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | Income and FICA taxes | Value of stock at vest | 39.35% |
| Sale (< 12 months) | Income tax and NIIT | Gains on stock since vest | 40.8% |
| Sale (>= 12 months) | Capital gains tax and NIIT | Gains on stock since vest | 23.8% |
However, FICA taxes and NIIT are only levied on US tax residents. Further, the US does not tax capital gains (short-term or long-term) for non-residents, so in practice only the grant and vesting rows of the first table apply to a US non-resident who is subject to US source taxation.
🐻Californian taxes: Restricted Stock Units (RSUs)
California takes a fairly similar view of RSUs to the US federally, however it does not treat long-term capital gains differently to short-term. This simplifies the tax table, at the expense of paying more taxes on long-term gains.
Further, while California doesn’t have FICA taxes or NIIT, it instead has an additional 1% tax created by the Mental Health Services Act. Unlike its federal equivalents, this tax is levied on Californian non-residents.
California’s income tax brackets for 2020 range from 1% to 12.3%, giving us the following table for both residents:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | Income and MHSA taxes | Value of stock at vest | 13.3% |
| Sale | Income and MHSA taxes | Gains on stock since vest | 13.3% |
California does not tax the sale of stock for non-residents, so the sale row above isn’t relevant in that situation.
📚Putting it all together: Restricted Stock Units (RSUs)
Putting these different tax jurisdictions together yields the following tax rates on RSUs across the US and California, for a US and Californian resident:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | US Income, US FICA, Cal income, Cal MHSA | Value of stock at vest | 52.65% |
| Sale (< 12 months) | US Income, US NIIT, Cal income, Cal MHSA | Gains on stock since vest | 54.1% |
| Sale (>= 12 months) | US Capital gains, US NIIT, Cal income, Cal MHSA | Gains on stock since vest | 37.1% |
And for a non-US resident at time of vest and sale:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | US Income, Cal Income, Cal MHSA | Value of stock at vest | 50.3% |
| Sale (< 12 months) | None | N/A | N/A |
| Sale (>= 12 months) | None | N/A | N/A |
🇺🇸Federal US taxes: Non-qualified Stock Options (NSOs)
The problem with RSUs for a private company is one of liquidity: you don’t want your employees having to pay tax for an asset that can’t be sold (because that creates a liability for them). In order to avoid that, you need to add that “double-trigger” clause to the vesting schedule, however this means that your employees will pay income tax on the entirely of their gains once a liquidity event does occur.
Ideally, you’d like your employees to be able to opt into capital gains tax status earlier, if they so choose, since that leads to lower tax rates. This is typically achieved by granting employees options, which are the right to acquire stock at a fixed price, rather than giving them stock directly, as with an RSU. Options have a new tax event over RSUs, which occurs when the employee chooses to exercise their right to acquire stock in exchange for their options.
Generally speaking, tech companies grant their options with no discount or additional cost, i.e. the fixed price you must pay to acquire stock is generally the company’s fair market value on the day it is granted (for private companies this is determined by an independent party, and is called a 409A value). This means that from a tax perspective, the thing you’re being given is worthless: you’re being given the right to pay $1 for $1 worth of company. As such, you’re not taxed at either grant or vest, only when you choose to exercise that right at a later date, when the value of the underlying stock has changed. Presumably, you’d only choose to do this if you’d make a profit from the endeavor, i.e. if the company’s stock value had increased above the price you needed to pay to exercise it.
For an NSO (distinct from an ISO, which we’ll cover shortly) that leads to the following tax treatments:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | None | N/A | N/A |
| Exercise | Income and FICA taxes | Value of stock less cost to exercise | 39.35% |
| Sale (< 12 months) | Income tax and NIIT | Gains on stock since exercise | 40.8% |
| Sale (>= 12 months) | Capital gains tax and NIIT | Gains on stock since exercise | 23.8% |
🐻Californian taxes: Non-qualified Stock Options (NSOs)
Once again, California takes a fairly similar view to the US federally when it comes to NSOs. Rather than being taxed at vest, they’re taxed at exercise, and as with everything in California, are subject to income and MHSA taxes.
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | None | N/A | N/A |
| Exercise | Income and MHSA taxes | Value of stock less cost to exercise | 13.3% |
| Sale | Income and MHSA taxes | Gains on stock since exercise | 13.3% |
📚Putting it all together: Non-qualified Stock Options (NSOs)
Combining the two different tax jurisdictions again, we get the following table for US and Californian residents at each point:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | None | N/A | N/A |
| Exercise | US Income, US FICA, Cal Income, Cal MHSA | Value of stock less cost to exercise | 52.65% |
| Sale (< 12 months) | US Income, US NIIT, Cal Income, Cal MHSA | Gains on stock since exercise | 54.1% |
| Sale (>= 12 months) | US Capital gains, US NIIT, Cal Income, Cal MHSA | Gains on stock since exercise | 37.1% |
For non-residents, California levies tax at exercise but still not at sale, so a non-US resident at each of vest, exercise, and sale, would see the following tax treatment:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | None | N/A | N/A |
| Exercise | US Income, US FICA, Cal Income, Cal MHSA | Value of stock less cost to exercise | 52.65% |
| Sale (< 12 months) | None | N/A | N/A |
| Sale (>= 12 months) | None | N/A | N/A |
Note that each of these tables are identical to the taxation status of an RSU, except that an employee is now able to choose when the taxation point will be hit. They can choose to exercise earlier and have more of their earnings taxed as capital gains, or they can wait until later when a return is more certain, and can have their options taxed the same way that they would be as RSUs.
The downsides to NSOs are that they do require capital to exercise: using them as a form of compensation is more advantageous to well-off employees, and that they are only valuable to the extent that the value of the company continues to increase. As companies get larger, they tend to move away from granting NSOs to instead grant RSUs, since reasoning about the value of RSUs for an offer is often simpler for candidates.
🕰Federal US taxes: Incentive Stock Options (ISOs), a history
ISOs are where things get complicated, so we’ll take a brief trip into history to understand what led to this situation in the first place. (If this sounds boring to you, and you’re familiar with AMT, you can skip to the next section).
Although I’ve described how NSOs are taxed in the US, this definition is based entirely on common law: there are no statutes describing how NSOs should actually be taxed (incidentally, this is why NSOs are also known as “non-statutory stock options”, in addition to “non-qualifying stock options”).
Before ISOs existed, this was problematic: when you granted an option to an employee, were the gains they realized capital or compensatory in nature, i.e. were they taxed under the income tax or capital gains tax system? Back in the 1940s, this determination was based on “individual circumstances”, for example where the original agreement was communicated as compensation, and the relative value of the cost of exercise to the company’s fair market value at the time of the grant. This decision was often complicated by common clauses that prevented an employee from exercising their options after leaving a company, making them seem more compensatory in nature.
The Revenue Act of 1950 (jokingly known at the time as the “Loophole Closing and Opening Act”), sought to remedy this situation by creating a special class of options, defined in statutes, that were guaranteed to be capital. These “restricted stock options”, which went on to become ISOs, would not be taxed at exercise, only at sale, and only at capital gains rates. They also had a number of restrictions attached to them, to prevent them from being used for non-employees.
When they were first introduced, these restrictions focused on how the options could be transferred to others, how long they had to be held for before sale, and how much of a discount could be provided relative to the company’s fair market value. However, when you create tax loopholes, people use them in unexpected ways, and so the set of restrictions on ISOs has been added to over the years. These additions include restrictions on the total value of ISOs an individual can be granted (added in 1980), and a requirement that options be granted at no less than the company’s current fair market value (added in 2004).
However, the most impactful change to the tax status of ISOs occurred as a result of the introduction of the Alternative Minimum Tax, or AMT, in 1982. This tax was originally created to prevent very high income households from taking so many deductions that they paid no regular income tax at all. Many of these households benefited from the loopholes created for ISOs, and so the “bargain element” of an ISO at the time of exercise was included as income under the AMT system. This “bargain element” is the difference between the fair market value of the option at the time of exercise, and the price you had to pay in order to exercise it (typically the fair market value at the time of grant).
AMT operates in parallel with the regular US income tax system. Any income counted in the regular income tax system is included in your AMT income, along with some additional AMT-only income, such as the bargain element of ISOs that are exercised. The AMT system has a lower maximum tax rate (28%), and a higher tax-free threshold, but permits very few of the deductions allowed by the regular income tax system. You calculate your tax burden from the regular system, and from the AMT system, then pay the higher of the two, in any given year.
The creation of “AMT-only” income means that the cost basis you have for an asset (that is, the amount that you are considered to have paid in order to acquire the asset, and which you’re not taxed on when you realize a gain) can be different in the two systems. To prevent this from causing double taxation in the case where you pay AMT one year, but regular income tax in a latter year, each time you pay AMT you receive a credit. This credit is the amount of additional tax, above the regular income tax system, that you were required to pay under AMT. In any subsequent year where you pay under the regular tax system, you can use your AMT credit to lower the amount of tax you’re required to pay to the level you would pay under the AMT system in that year.
Capital gains tax exists in the AMT system, and the rates are the same as under the regular income tax system, but apply to the gains that the AMT system considers you to have received.
Functionally for ISOs, this means that AMT acts as a sort of prepayment system: although it causes a higher tax burden at exercise time, you’ll typically get at least some of that money back as a tax credit on later returns. This breaks down in a few cases, such as where you don’t pay more tax later. For exmaple, if the value of your options decreases, does not increase enough, or if you aren’t required to file later US tax returns.
🧮Federal US taxes: Incentive Stock Options (ISOs), in practice
That’s all a lot to take in, so let’s run through a worked example. Let’s say you were granted ISOs with a strike price (i.e. cost to exercise) of $1, exercised them 2 years later when the company’s FMV is $3, and sold the underlying stock another 2 years later, at a value of $6.
When you exercise, you recognize no income under the regular income tax system (part of the “incentive” of ISOs), but you do recognize some under AMT. Your “bargain element” is the company’s fair market value less the price you paid to exercise, so $2. Assuming that you pay AMT at the highest rates, you’ll pay 28% tax on this income, which would be $0.56.
Assuming that you exercise enough ISOs in that year, your tax burden under the AMT system will be higher (since for every option you exercise you add $0.56 of AMT and $0 of regular tax), and you’ll pay under the AMT system, rather than the regular tax system, that year.
When you sell, you recognize capital gains under the regular income tax system, rather than income (the other part of the “incentive” of ISOs). These gains are from the sale price down to the original cost to exercise, i.e. $5. Since you’ve held the options for more than two years, these are long-term capital gains, so you’d pay at most 20% on them, or $1 in tax.
You also recognize capital gains under the AMT tax system at sale, however the gains are only on the difference from the sale price to the fair market value at time of exercise (since under AMT you’ve paid tax on the rest of the asset already). This means you have $3 of gain under the AMT system, at a 20% rate, yielding $0.60 more tax.
In the year of sale, assuming you sell enough shares that were originally ISOs, your tax burden under the regular system will be higher (for every share sold, you add $1 of regular income tax, but only $0.60 of AMT). However, you’ll have an AMT credit available from the year that you exercised. That year, you paid an additional $0.56 over the regular income tax system by paying under the AMT system, which means you can claim a credit of up to that much back on this return. However, you can only reduce your tax burden down to the amount of AMT that you’re required to pay, i.e. a reduction of $0.40 to $0.60 in the year of sale. This means that you’d use up $0.40 of your credit, but would have another $0.16 available for a future tax year in which your regular income tax was higher.
In the end, you’ll have paid $0.56 + $0.60 = $1.16 of tax on a gain of $5, giving a tax rate of 23.2%. Had this instead been an NSO, the tax rate would have been 26.8%. If instead the company’s value had increased further by the time you had sold, e.g. to $10, you’d be able to claim back the entire AMT credit you’d paid at exercise, and would have a tax rate of exactly 20%.
Note that in addition to each of these taxes, you’ll still be required to pay Net Investment Income Tax at the time of sale on your total gain, adding an additional 3.8% tax.
🇺🇸Federal US taxes: Incentive Stock Options (ISOs), summarizing
To wrap up our discussion on ISOs, we also need to mention what happens if you choose to violate the restrictions required for their preferential treatment. For example, if you sell an ISO within 12 months of exercising it, or 2 years of its grant. In this case, a “disqualifying disposition” (aka disqualifying sale) has occurred, your ISO reverts to NSO status, and you lose the tax advantage it would typically have given you.
Taking all of this into account gives us the following US federal tax table for qualifying dispositions of ISOs:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | None | N/A | N/A |
| Exercise | AMT | FMV at exercise less cost to exercise | 28% |
| Sale (if AMT is higher) | Capital gains tax and NIIT | Value of stock less FMV at exercise (CGT), value of stock less cost to exercise (NIIT) | 20% + 3.8% |
| Sale (if regular tax is higher) | Capital gains tax and NIIT | Value of stock less cost to exercise (CGT and NIIT), less AMT previously paid, down to the AMT amount in the row above | 23.8% (full gains), less prior AMT |
As before, NIIT isn’t levied on non-US tax residents, nor are capital gains taxes, so a non-US tax resident can ignore the two Sale rows.
🐻Californian taxes: Incentive Stock Options (ISOs)
California has the same requirements for ISOs as the US federally, so the tax table looks functionally the same, with different numbers. The AMT rate in California is 7% and AMT credits are also available.
This gives the following table for qualifying dispositions of ISOs:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | None | N/A | N/A |
| Exercise | AMT | FMV at exercise less cost to exercise | 7% |
| Sale (AMT higher) | Income and MHSA | Value of stock less FMV at exercise | 13.3% |
| Sale (Regular tax higher) | Income and MHSA | Value of stock less cost to exercise (Income and MHSA), less AMT previously paid, down to the AMT amount in the row above | 13.3% (full gains), less prior AMT |
📚Putting it all together: Incentive Stock Options (ISOs)
And combining both of these tax tables gives the following overall status for qualifying ISO sales:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | None | N/A | N/A |
| Exercise | US AMT, Cal AMT | FMV at exercise less cost to exercise | 35% |
| Sale (if AMT is higher) | US Capital gains, US NIIT, Cal Income, Cal MHSA | Value of stock less FMV at exercise (CGT, Cal income tax, MHSA), value of stock less cost to exercise (NIIT) | 33.3% + 3.8% |
| Sale (if regular tax is higher) | US Capital gains, US NIIT, Cal Income, Cal MHSA | Value of stock less cost to exercise (CGT, NIIT, Cal income tax, MHSA), less AMT previously paid, down to the AMT amount in the row above | 37.1% (full gains), less prior AMT |
For non-residents, we’d instead get this table:
| Event | Tax type | Taxed amount | Highest tax rate |
|---|---|---|---|
| Grant | None | N/A | N/A |
| Vest | None | N/A | N/A |
| Exercise | US AMT, Cal AMT | FMV at exercise less cost to exercise | 35% |
| Sale | None | N/A | N/A |
It’s worth noting that this means that non-residents exclusively pay AMT on their ISOs when exercising internationally, and are unlikely to have sufficient regular income to receive this back as a credit in the future.
🎁Wrapping up
As has hopefully become clear, a big complication in the US tax system as it pertains to equity is the existence of ISOs and AMT. While there are a confusing series of taxes that apply to each class of equity, the existence of an intentionally tax preferential type of option, combined with two parallel tax systems, makes it quite difficult to reason about just how much tax you’ll end up paying.
One other, final factor in the US tax system is that it is a joint assessment system: if you are married (or in a similar relationship recognized by the assessment authorities), you’re generally expected to file a single tax return each year declaring your combined incomes. Further, California is a community property state, which means that assets earned while married in California are considered to belong to the relationship, rather than each individual. This community property status makes little to no difference when filing joint returns, but can introduce problems when you later move to a separate property state (e.g. another country or 43 of the other US states).
Before discussing that issue though, we’ll need to understand another country’s tax system, so that we can see where the sharp edges between the different systems come into play.
In the next post, I’ll cover Australian equity taxation, and then we’ll put everything we’ve learned back together to see the sorts of things that go wrong when filing international taxes with equity.