A Big Tax Problem
Please, do not forget to pay payroll tax when you issue options 🙏🙏🙏
I am sorry to be the bearer of bad news but, if you’re a startup that is issuing options and that is required to pay payroll tax, there is a good chance you’ve dealt with the subject of this article incorrectly and it could cost you, a lot.
Taxable wages for payroll tax purposes include options that you grant to employees, typically under employee options plans in the case of startups. While this might seem a little esoteric, it’s a ubiquitous issue and if you’re a founder, it’s probably very relevant to you. I implore you to take note.
I’ll start at the punchline: if you issue options and you don’t elect to pay payroll tax at the grant time, you are likely to get a much bigger tax bill in the future.
Here’s why….
Potential Payroll Tax Outcomes
Generally, you will pay payroll tax based on the value of an option calculated either at the grant date or the vesting day. How to calculate the tax payable is explored further below. Here I explore the outcomes of these two scenarios.
Scenario 1 - taxed based on the grant date
You are a company with 10 million shares and a valuation of $10M. If you grant options over 1 million shares with a strike price of $1 per share (the current share price of the company), the option isn’t worth a whole lot. The reason is that at best, this is an option to buy shares at their current price. If you consider that these are probably options to purchase ordinary shares (that are worth less than the preference shares you likely issued to investors at the $1 share price), this isn’t a very valuable option. If you calculate the value of the option on the grant date and pay tax on that basis, you probably won’t get a big tax bill - happy days.
Scenario 2 - taxed based on the vesting day
The vesting day of options that your above mentioned $10M company issues is (under the relevant legislation) the earliest of:
the date on which the employee exercises the option; or
7 years after the date that the option is granted.
6 years after the issue of the options, the relevant employee exercises the options. The valuation of your company is doubling every 2 years. At the time of exercise your valuation is 64x what it was 6 years ago, that’s $640M or $64 per share. If you are taxed based on the option value on the vesting day, you will now need to pay payroll tax based on the value of an option to buy shares at $1 when they are worth closer to $64. Even accounting for a discount, as per Scenario 1, the share price has appreciated enormously. That IS a very valuable option and as such, if you calculate the value of the option on the vesting date your tax bill, well it’s going to be a hell of a lot bigger - uhoh.
The Law
All (NSW) employers must pay payroll tax if their salary base is greater than $1.2M a year . As an employer, you have the choice to elect to tax options at either the grant date or the vesting date. These terms are defined for payroll tax purposes. If you do not include the options as taxable wages in your payroll tax return, you are deemed to elect to tax the options on the vesting date. This could be a disaster.
There is only one exception to this – if you are able to demonstrate that there would be no payroll tax at the grant date if an election had been made to tax on that date. In other words, the market value of the option must be $0. Good luck with that one.
If you elect to tax the options on the vesting date, or you are deemed to elect to tax the options on the vesting date, the option is taxable as the earliest of:
the date on which the employee exercises the option; or
7 years after the date that the option is granted.
The amount of payroll tax payable is, at your election:
the market value of that option at the taxing point; or
the greater of:
the market value of the underlying shares, less the exercise price; or
the amount worked out under the evaluation table in the income tax regulations.
This table sets this out clearly:
The bottom line: if you forget to elect to pay payroll tax on options you issue, you have a problem.
Friends, please, don’t forget to pay payroll tax when you issue options.
If you know someone that could benefit from reading this article…
Disclaimer: this article contains general information only. It is not legal advice and does not take into account your personal circumstances. It has not been verified and may contain errors. You should independent legal advice in relation to the matter referred to in this article.