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How to make an IPO tax withholding selection that works for you.
If you’re a tech employee with a looming IPO, you’ve got a potentially life-changing payday to look forward to.
But before you get too excited, you need to make some big decisions.
No, not about how soon you’ll retire or what international vacation you’ll book — at least not yet.
What you need to decide is how to handle IPO tax withholding. In other words, should you select 22% or 37% withholding?
Let’s review some IPO tax basics
Before we get into withholding selections, let’s cover some basics about IPO tax withholding.
As far as payroll tax withholding is concerned, equity compensation is considered a supplemental wage. This is similar to how bonuses and commissions are treated.
Employers who compensate employees for supplemental wages are required to withhold a portion of the money based on the federal supplemental withholding rate. This withholding rate is 22% until you reach $1 million in supplemental wages. To be clear, that’s $1 million in supplemental wages only and does not include your salary.
Beware, as taxes usually outpace large supplemental wages, resulting in hefty tax bills that can be jarring for some. This issue becomes even more pressing as your company offers large liquidity events, such as IPOs and tender offers. If you’ve been receiving double-trigger restricted stock units (RSUs) from your private company, you’ll have a significant decrease in income once they go public. For instance, you can suddenly have $950,000 in double-trigger RSU compensation this year, but it’s only had 22% withholding up until this point. Now, you’re well into the 37% tax bracket and start to see the shortfall in taxes owed versus what was withheld.
Tech employees like receiving equity compensation but hate the surprise tax bills that come with them. In response, your employer may offer an accelerated withholding rate of your supplemental wages. Commonly, employers offer 37% federal withholding or the standard 22%. You usually have to fill out some forms to make this election with your employer, but it’s relatively simple.
That’s when you enter a new playing field, where you decide between two courses of action. You either:
1. Elect to keep the standard withholding rate of 22%, which will most likely give you a shortfall come tax return filing season unless you make estimated tax payments.
2. Elect for the higher supplemental withholding rate of 37%, which means you may have withheld too much, but you’d ultimately receive any excess payments back on your tax return filing.
Those two paths are simplified, but you should consider other factors that are more particular to your situation. Ask yourself:
- Will I have enough cash flow to pay the balance due with my tax return?
- If I elect 22% withholding, will I have enough cash to pay the required estimated tax payments?
- If I elect 22% withholding and wait to pay with my return, am I okay with possibly paying penalties and interest to the IRS for failure to remit estimated tax payments?
- If I elect 22% withholding and have a balance due, I have to accept that the stock price could go down on my holdings. This means I’d have to sell more shares to satisfy my tax obligations. Am I okay with that?
- If I elect 37% withholding, I’ll have to sell more shares. Am I okay with diluting my concentrated stock position?
- When will my lockup end or when will the next trading window be, so that I can possibly gather additional funds needed for tax liabilities?
- I have a large minimum tax credit, so my overpayment with the 37% withholding rate may be even larger than anticipated. Am I okay with that?
Considerations for IPO tax withholding selections
The above are great questions we hear often, especially when a large tech company goes public. So let’s dig into these topics:
Tax return balance: Your tax return — in a normal year, if those even exist anymore — is going to be April 15. You might think you can extend your return, but the IRS requires that extended returns still have their tax liability paid by the April deadline. The extension only allows you further time to file the return but any unpaid balance is still subject to failure-to-pay penalties and interest. The current IRS interest rate is 8%, so you want to ensure you have the cash funds ready to pay in April, especially on a large balance due.
Estimated tax payments: Say you elect 22% and know you must pay a portion of your tax liability to the IRS throughout the year manually. This means you pay the IRS directly via paper check or through their online payment portal. Withholdings are managed and remitted by your employer, making them one more thing off your plate. When withholding doesn’t keep up with tax liability, the IRS has you make payments that equal the lesser of:
- 90% of the current year tax liability
- 110% of the prior year tax liability
When I say tax liability, I don’t mean the number you ultimately paid with your return; I’m referring to the taxes you were subject to prior to your withholding and estimated tax payments reducing it. After pinpointing which is the lesser payment method, you then reduce that by any withholdings you’ll have for the year. The amount left is your required estimated tax payment amount. The payment deadlines are quarterly, so depending on when you’re running it you divide the amount by the quarters left in the year. The bright side is that these payments reduce your tax return balance due, helping you avoid underpayment penalties and applicable interest.
Cash flow planning: The 37% withholding rate will probably give you the most peace of mind when it comes to cash flow planning. Rather than make estimated tax payments or remit balances due with your return, it’s likely you’ll have a refund. With 22% withholding, you now have to consider when your lockup period ends for the IPO. For some, it can be 180 days or at other companies, an established date. You want to be sure that when you have payments due, you either have enough cash around to remit or you can sell enough shares to remit the balances.
Stock market movement: I want everyone to know I’m still looking for the elusive crystal ball that will let me be the most effective tax advisor in the world. But in reality, there’s no such thing. The bottom line is, we can’t predict the future. Your company could IPO at $50 per share and be worth a fraction of that six months later. Alternatively, the stock could be worth triple that. Either way, you have to accept that if you’re going to generate cash flows from selling company equity, you’ll be taxed at the IPO price no matter what the market does. If the stock loses value, you can’t reduce wages when you sell the double-trigger RSUs.
Keep in mind, current laws state the maximum capital loss you can claim each year is only $3,000. The tax is based on the day that the shares were released to you in the IPO, assuming you were completely vested. The best way to work around this is by setting an exit price and committing to selling — even if it’s only a portion of your shares — when your stock reaches those prices.
Large tax credit carryovers: If you were proactive prior to your IPO and have been exercising your incentive stock options (ISOs), you may have paid alternative minimum tax (AMT). This tax transforms into a credit known as the minimum tax credit (MTC). It’s not uncommon for individuals to have large credit carryovers in these circumstances, but you must remember the tax credit won’t reduce your tax liability to $0. It’ll simply reduce the tax credit to the current year’s difference between ordinary tax rates and alternative minimum tax rates.
Given this, you may find that even with the tax credit, your 22% withholding will not be enough to keep up with your tax liability. It’ll certainly reduce the taxes — which is awesome — but still plan to most likely have a balance. In which case, accept that the 37% withholding will most likely generate an even larger tax refund. The flip side is that you still have a balance due with 22% withholding.
When I make client recommendations, I look at each individual’s circumstances. Questions I consider include:
- How much are they vesting upon the IPO?
- What will their wages look like that year?
- Do they carry large cash reserves?
- Do they have a large credit carryover?
- What type of equity are they selling (RSUs, ISOs, non-qualified stock options)?
- What will their tax rate most likely be this year due to the IPO?
In most cases, it’s not a one-glove approach. It really depends on the individual, their feelings and mentality on their equity, their financial situation, and particular grant agreements.
All of this to say, it’s a lot of work. But golly, what a great thing to work on.
Get to work now, reap the benefits later
IPOs are life changing for executives, employees, and other company equity holders.
Congratulations! You’ve probably worked incredibly hard in conjunction with the company to get to this point. Now, it’s time to reap the benefits, plan properly, and set yourself up for ongoing success well past the company’s IPO.
That starts with enlisting help from financial advisors who’ve been there and done that with countless other tech employees.
Book a call today to talk to myself or another expert on our team about preparing for your IPO so you can be at ease when the big day comes.
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