How (and How Not) to Pay with Equity


More and more, I’m hearing frustration from post-revenue or post-capital raise corporations that want to pay new hires in common stock.

It seems like an obvious win-win: a new hire, with faith in the company’s success, gets paid in common stock for a future pay day, and the company can commit the cash it would otherwise need to pay an employee towards company growth.

However, the IRS views paying in stock as income. That means, when the company issues stock instead of a check to the new hire, the IRS still sees that as payment for work—hence, income—hence, income tax.

If a new hire were paid $35k worth of stock that year, that’s income tax liability on $35k. Even in the 12% bracket, that’s $4,200 due in income tax.

This might seem unfair at first: the hire isn’t receiving cash and the stock could become less valuable. Sometimes, for startups that fail, the value can go to zero. The person could pay $4,200 in taxes for stock valued at $35k with no guarantee the stock will be worth anything 5 years later. She might end up paying $4,200 in taxes for an asset that ends up being worth nothing!

But the IRS’s view closes a major loophole for income tax—namely, that if providing non-cash as payment avoided income tax, everyone would do it.

For instance, a development company would hire a contractor to build an apartment complex and pay them by giving them 5 condos in the building. No cash, no income! The contractor could then rent or sell those condos. (But, of course, that payment for the contractor’s work would be considered income.)

Ultimately, when your stock has an appreciable fair market value, that means stock grants are transferring something with a market value to the hire. It’s the same as giving your hires a car or a condo as payment for work—it’s just another way to pay.

(If you’re having the idea of avoiding income tax by “gifting” stock to hires, stop. Although the IRS allows annual tax-free gifts under a certain amount, those must be gifts. If they are tied to goods or services—i.e. you’re “giving” stock to a hire to reward or compensation them for work—they are no longer gifts.)

Solution: As I wrote in more detail here, once your company has value, the best path for giving someone stock in your company, and the one that almost always makes the most sense, is to set up a stock option plan. If your company follows the applicable regulations, hires will receive more favorable tax treatment for their options.

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