New Bernie Sanders proposal to raise taxes on executive compensation stock options earlier could hit start-up workers

Bernie Sanders, the self proclaimed Democratic “socialist” front-runner, citing new GAO report, calls for taxing executive retirement plans (which are selectively given to key executives in order to incentivize them to stay with a company) and stock options sooner.  Mr Sanders new proposal would sharply curb the tax benefits of executives’ retirement plans (known as SEC. 409A. nonqualified deferred compensation) and require earlier taxation of stock options in a proposal that could dramatically alter compensation at major U.S. companies.  The WSJ and CNBC both reported on this development on Feb. 27, 2020, where he introduced a plan which cites a new gov accountability office report. The analysis found that executive deferred pay plans at the 500 largest companies totalled 13 billion in assets in 2017, just considering the the top executives at each firm or about 2,300 people.  

The average CEO has about $14 million in his or her account; some CEOs have more than $200 million. Many of these CEOs have already maxed out their 401(k) and IRA limited tax-advantaged plans, and these special plans allow wealthy executives to circumvent traditional IRS limitations and oversight. 

The Democratic presidential candidate, along with Sen. Chris Van Hollen, D-Md., proposed the CEO and Worker Pension Act on last Thursday. Now this bill that would raise taxes on executive retirement plans could hit an unintended target: employees at start-ups.

• This proposal would also change the tax treatment on stock options for individuals earning at least $130,000 a year.
• Under this bill, workers receiving equity compensation could wind up paying taxes sooner than they expect.
• That means it would be most likely affect employees at later-stage startups, where the strike prices are higher.
• The proposal doesn’t have a grandfather clause, but does include a nine-year transition period (i.e., this wouldn’t apply until paying 2029 taxes).

According to the Darla Mercado, a CNBC contributor, “the legislation takes aim at so-called nonqualified deferred compensation plans, which allow executives to sock away a portion of their pay — above and beyond what they would otherwise save in a 401(k) plan — and defer taxes for years until the money is distributed.”  The Sanders new proposed tax bill would curb this deferral, levying taxes on executives’ savings earlier.  According to reporting from Fox Business “the plan would raise an estimated $15 billion,” said Sanders’ office. All revenue raised from the changes to the tax treatment of nonqualified deferred compensation will be transferred from the Treasury to the Pension Benefit Guaranty
Corporation to shore up multi-employer pensions. 

Now given that it is a divided congress, the likely hood of the bill getting passed into law is probably not so high but it offers a clue into Sanders’ thinking as he campaigns for office.  

On top of that, equity-based compensation would also be subject to this new treatment, accelerating taxes on nonqualified stock options paid to high-earning employees. 

Restricted stock units, which employers also use to grant shares to workers, would also be subject to the bill.   

Now Mr. Sanders said in a statement “we are ending a two-tiered system that gives special tax breaks to billions of dollars in corporate executives’ savings while letting workers’ pensions disappear,”

Samuel Deane, founder of Deane Financial Partners in New York spoke with CNBC and said “this recent proposal would do more harm than good for many employees, especially those in the Silicon Valley ecosystem where nonqualified stock options are extremely popular.”    

Many CPAs and tax advisors feel the treatment of stock-based compensation would hit employees at startups right in the pocketbook.  

New startup companies may not have the cash on hand to afford huge salaries, so they attract and retain talent by granting workers a stake in what could be the next Twitter, Uber or Google. 

Mr. Deane also stated “taxing stock options at vesting won’t hurt high-net worth executives as much as it would hurt middle-class employees who may not be able to afford the tax bill.”   

In a NYT article titled “Silicon Valley Leaders’ Plea to Democrats: Anyone but Sanders” the reporters spoke with a few venture capitalists who are concerned with Mr. Sanders and his most aggressive attack on the tech industry, the proposed earlier taxation on stock options, the equity that has fueled the wealth of many in Silicon Valley.   Last week, Adam Nash, a tech investor and former executive at Dropbox, wrote on Twitter, about the proposal “If your goal was to destroy the Silicon Valley ecosystem of creating new companies, this would be an effective way to do it.”

CNBC’s reporting explains that “stock options allow workers to buy a specified amount of stock at a stated price — known as the strike price — after a vesting period at some point in the future.”   When you exercise the option, you buy the stock at the strike price.

Currently, nonqualified stock options are subject to ordinary income tax rates — which are as high as 37% — at exercise. The tax applies to the bargain element, which is the difference between the strike price and the sale price.

If your shares appreciate and you sell them, you pay a capital gains tax, also.   

Under the Sanders bill, workers with compensation of at least $130,000 who are getting nonqualified stock options would face taxes once they are able to exercise — regardless of whether they choose to do so.

This means the employees could be on the hook for taxes and have no cash to pay the bill.

“If you earn a couple million a year, you’re likely to have the cash and flexibility to pay the taxes,” said Dan Herron, CPA and principal of Elemental Wealth Advisors. He went on to say “If you have highly-valued options, you make $150,000 a year and you live in San Francisco? You’re going to get screwed.”  

Axios reporter Dan Primack reported on this and pointed out why iit matters: Many of the affected employees, even though well-compensated, may be unable to afford the taxes.

• Imagine you make $130,000 per year at a privately held company and have $200,000 worth of annual options vesting.
• You obviously are required to pay regular taxes on your $130,000 income, but now also must pay taxes on $100,000 worth of stock options (again, the first $100k is excluded).
• Or, put another way, you make $130,000 but are paying taxes on $230,000.
  • Not only might you not have the cash, but there’s also the possibility that the stock will later go to zero or liquidate lower than your strike price — but the bill includes no claw-back mechanism. So you’ve now paid taxes on money you never saw.    

An early employee of Uber Ryan Graves who became wealthy in the IPO expressed his feelings about this proposal.

I wanted to like him, but he’s a clown.

He doesn’t hate rich people he hates any person that has aspirations of building any wealth.

This is a direct attack against the American dream. https://t.co/RN3YIwkU74

— =Ryan Graves= (@ryangraves) February 29, 2020

Smaller startup company risks 

As of now the current laws are written that, under certain circumstances, employees at private companies who receive stock options or restricted stock units may defer income taxes for up to five years when they exercise those options.

This treatment isn’t affected by the new bill. In that case, workers with illiquid stocks can still hold off on taxes.

However, employees at small private companies face the problem of finding a market to sell their shares. There aren’t many eligible buyers for those holdings.   

“In the private market, there isn’t any liquid demand for these securities,” said Deane.

Not all startups grow into Google or Amazon of course.

Last year had its share of unicorns that failed to take off such as Wework when they debuted on the public market.  Michael Goodman, CPA and president of Wealthstream Advisors in New York raises an interesting and valid question “we always hear about the Apples and Googles, but what about the companies whose prices went down?”   

Changing compensation 

The bill could also affect the way companies pay their workers.

It may lead more employers to pay cash bonuses that’s tied to meeting a performance goal instead of using deferred compensation.

“I would think that if these new proposed regulations were implemented, CEOs would utilize options that were easier to plan,” said Herron.

In particular, executives might be more inclined to use employee stock purchase plans, which allow workers to buy stocks at a discounted price, and incentive stock options, which aren’t taxable at receipt or exercise.

Incentive stock options are not part of the Sanders proposal.

With ISOs, workers can qualify for favorable capital gains treatment — a tax rate that’s typically 15% — when they sell the shares they bought, provided they meet a set of conditions.

Conclusion 

The bottom line: This isn’t completely about how much people pay in taxes. It’s about when they pay it. It would make more sense for the timing to match the receipt. The proposal also comes as Sanders targets union support in his bid to win the 2020 Democratic nomination. However, $15 billion would not go very far toward addressing the pension plan funding gap. As of fiscal 2017, state pension plans had a combined $1.28 trillion deficit.