ESOPs & Trusts – How to Avoid a Common Structuring Trap

The old regime for ESS (pre-2015) taxed employee participants at vesting when their ESS interests (either shares or options/rights) were (or related to) small shareholdings in highly illiquid companies. Because of the high failure rate of start-up companies their value was questionable. Employee participants paid taxes on this income (up to 45 percent + medicare levies) at vesting only for those companies to fall over, with participants unlikely to derive a cash benefit (and if an offer came out of nowhere, many employees with vested but unexercised options were caught short in this regard).

As a way to fix the problems above, the 2015 Amendments added a “eligible startup concession” for ESOPs. This meant that employees would not be taxed at the time of ESOP issue, nor at the time of ESOP vesting or at the time of ESOP exercise. Instead, they would only be taxed when the ESOP shares were sold after they were exercised.

Most people assume the application of the general 50% discount being applied after sale of shares. It is important to be aware of the 12 month holding rule here. If you buy shares after you exercise options under a normal ESS, you also have to hold on to them for at least 12 months before you can sell them.

Unlike in general CGT rules, when an option is exercised and a share is issued, the start date for the 12 month holding period requirement isn’t reset when both of these things happen. Instead, the two assets are treated as a single asset in the instance of a Startup ESOP.

Putting your assets in a family trust can assist with asset protection and aid with tax planning in the future. Eligible ESOP participants can nominate a family trust to also hold the options/shares on their behalf. For the purposes of the Income Tax Assessment Act 1997, those ESS interests are owned by the individual employee.

If the employee and another entity (such as the trustee of the family trust) are associated, this is called the “Associate Rule,” and this works to effectively ignore the family trust when the Startup ESOP rules apply. There is no taxable income that the employee has to pay taxes on upon share issue.

Trusts however are not the same when seeking to apply the 50% CGT discount. Startup ESOP options that are held by a family trust may be subject to a rule called the 12-Month Holding Period Rule if they are exercised and the trustee wants to sell the underlying stock. This raises a question about when the options were exercised for the purpose of determining the holding period.

Among other things, the rules for acquisition under the CGT regime say that when an acquirer exercises an ESS interest (such as an option or a right under an ESS), those interests are bought. The startup ESOP rules are used to reduce how much an acquirer has to pay taxes on that income (options or rights).

The meaning of “acquirer” and how it works with the Associate Rule is complicated. Because of the Associate Rule, it is only the individual employee participant who can get tax breaks under the startup ESOP rules. So, even though the startup ESOP rules may cut the individual employee participant’s tax liability under the ESS tax regime, unless the options are given to the individual employee participant, the special acquisition rules for shares derived from startup ESOP options won’t apply. Instead, the general acquisition rules will apply, which means that the shares must be held for at least 12 months after the option is exercised to meet the 12 month holding period.

The startup ESOP rules can be very good for people who want to be able to access lower capital gains on shares they sell after exercising options under an ESS. Clients, on the other hand, need to be careful because a startup exit can happen at any time, so they need to make sure they meet the special acquisition rules for their shares. Otherwise, they might not be able to get a discount on capital gains taxes when they leave.