Any time someone calls me and asks about “warrants” I immediately ask, are you talking about a “compensatory warrant” or a “non-compensatory warrant”? The person on the other end of the phone isn’t always sure. This stems in part from the fact that the paperwork to document a warrant is frequently the same for both types.
Fortunately, the distinction is easy. If the warrant is issued for services, it is a compensatory warrant. Otherwise, it is a non-compensatory warrant.[1]Non-compensatory warrants are often issued as kickers in a debt or equity financing and for this reason are sometimes referred to as investment warrants.
Why does it matter? The tax treatment of these two types of warrants is very different.
Compensatory Warrants
A compensatory warrant is taxed just like a nonstatutory stock option. This is becauseit is a nonstatutory stock option. A compensatory warrant is a nonstatutory stock option because it is a right to purchase a certain number of shares, for a designated period of time, at a set price, and it doesn’t meet the requirements to be an incentive stock option. In fact, if you haven’t papered it yet my advice would be to use the term stock option in the paperwork to avoid this confusion and to remind everyone that rules like tax code Section 409A apply.[2]
So, what is the tax treatment? As long as the compensatory warrant is exempt from or complies with Section 409A, there is no tax on grant, but the spread at exercise will be ordinary wage income if the shares received are vested, or if unvested, if a tax code Section 83(b) election is filed. Any additional gain when the shares are sold will be capital gain, long-term if the shares were held more than one year.[3]
Non-compensatory Warrants
The receipt and exercise of a non-compensatory investment warrant is normally a non-taxable transaction, though it can cause ordinary issue discount (OID) problems when granted in connection with debt and certain types of preferred stock.
Tax consequences at disposition:
- If you hold such a warrant until a transaction and it is cashed-out, you can get long-term capital gain on the cash-out, as long as you’ve held the warrant for more than a year.
- If you exercise such a warrant with cash, and there is a taxable transaction later, you only get long-term capital gain if you have held the underlying shares for more than one year.
- If you net exercise such a warrant, under certain circ*mstances you may get to tack the holding period of the warrant to the shares received, increasing the likelihood of obtaining long-term capital gains treatment.
So oddly, you can actually worsen your tax treatment by exercising a non-compensatory warrant for cash. So often people don’t exercise such warrants, since you can get capital gains without exercising.
When might it make sense to exercise a non-compensatory warrant?
- If you want voting rights or to be able to participate in dividends.
- If the company is being sold and the transaction agreement requires that warrants exercise to participate in proceeds. OR
- If your warrant is an investment warrant in an entity taxed as a partnership and such entity is converting into a corporation. This is because exchanging your warrant for a warrant in the C corp would cause taxable income to the extent the value of the new warrant exceeds your basis in the original warrant, but exercising, receiving partnership equity, and then receiving stock in the new corporation in exchange for such partnership equity is usually not taxable.
Mike Baker frequently advises with respect to warrants and stock options. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] If it’s issued for unpaid parking tickets, that’s a real warrant!
[2] To avoid the adverse tax consequences of tax code Section 409A, including acceleration of tax and a 20% federal tax penalty, a compensatory warrant needs to either (i) have a fair market value exercise price and be issued on service recipient stock (generally common stock of the entity for which the service provider works), (ii) be issued to a service provider who qualifies as a Section 409A independent contractor through the entirety of each year in which the warrant vests, or (iii) comply with Section 409A by limiting exercise to the earlier of one or more Section 409A allowable events, which include death, disability, a separation from service, a change in control, or a fixed date (which can be as broad as calendar year but cannot cross calendar years).
[3]If unvested shares are received upon exercise and no tax code Section 83(b) election is filed, ordinary income will be recognized on the value of those shares at vesting (minus the exercise price), and the capital gains holding period will start on the vesting date.
