Equity Compensation as a Tool for Retaining Key Talent: Tax Considerations
Due to recent trends in the labor market, interest in offering equity compensation as a way to compete for and retain talent has grown quickly. Equity compensation is a payment in company equity typically granted to key employees and can act as a beneficial tool for companies looking to attract, retain, and incentivize top talent. While the advantage of providing equity compensation packages is clear from a business perspective, there are important legal implications.
This Article discusses the advantages, drawbacks, and tax and business considerations of the most common forms of equity compensation, including (1) restricted equity; (2) equity options; (3) phantom equity; and (4) profits interests. For purposes of this Article, “equity” is used broadly to refer to stock, units, partnership interests, or membership interests, depending on the state-law entity type involved.
General Considerations for Equity Compensation
When exploring the type of equity compensation to offer and the characteristics of the same, companies should be mindful of the following general principles:
- Entity Type Limitations. While any entity can grant equity compensation, not all forms of equity compensation are available to every type of entity. There are major differences in the awards that can be offered between entities taxed as partnerships, S corporations, and C corporations.
- Governing Documents. It is important for the issuing entity to review its governing documents to ensure the equity will be held as the current owners intend. This is often a good time to review and possibly revise voting thresholds, transfer restrictions, redemption rights, and the like.
- Depending on the type of equity, the issuing entity may be able to subject the award to vesting based on (1) the passage of time; (2) the option holder’s continued service with the company; (3) the achievement of specific performance criteria; or (4) a combination of the above. Generally, the equity can vest all at once or pursuant to a schedule set forth in the award agreement or similar documentation.
- Section 409A Compliance. Equity compensation, regardless of its form, is taxed to the employee or service provider as wages, unless an exception specifically applies. Because equity compensation is often subject to vesting, the taxation of the compensation can sometimes be deferred to a later tax year. Section 409A of the Internal Revenue Code (the “Code”) governs nonqualified deferred compensation, including many types of equity compensation. Code Section 409A imposes immediate taxation, plus a twenty percent (20%) excise tax, to the service provider on any nonqualified deferred compensation that does not comply with or meet an exception under Code Section 409A. Ensuring compliance with Code Section 409A (or one of its exceptions) is accordingly imperative when granting equity compensation.
- ERISA Compliance. Equity compensation awards may be subject to the Employee Retirement Income Security Act of 1974 (“ERISA”). One of ERISA’s requirements is that the equity award be granted pursuant to a written plan document that contains, among other requirements, details about eligibility for the award and information on vesting. Employers should consult with their ERISA counsel to ensure any equity compensation they intend to grant compiles with (or is exempt from) not only Code Section 409A, but also ERISA.
Advantages, Drawbacks, and Taxation of Equity Compensation Award Alternatives
A. Restricted Equity
Restricted equity awards grant employees actual ownership in the company on the grant date, so at that time, employees hold distribution and equity owner rights. Typically, the employee does not pay anything for the restricted equity award. The equity is restricted in that, until the restrictions lapse (i.e., when the equity vests), the shares or units are subject to forfeiture (typically on the termination of employment) and are non-transferable by the employee.
- Advantages to restricted equity awards include the following:
- The service provider is granted actual ownership in the company on the grant date, which can have retentive effect.
- The service provider has flexibility in electing when to be taxed (as discussed below).
- The awards do not include an exercise feature requiring a service provider to come up with cash to pay an exercise price.
- No valuation or appraisal of the value of the company’s stock is necessary.
- Disadvantages to restricted equity awards include the following:
- Time-vesting awards reward only aggregate company growth and not necessarily individual or business unit performance (when compared to, for example, an incentive bonus program).
- The current owners’ holdings are diluted by the service provider’s award upon grant.
- Taxation of Restricted Equity
Restricted equity awards are categorically exempt from Code Section 409A and are generally not subject to income tax to the employee at the time of grant. Instead, the service provider recognizes ordinary income on the excess of the fair market value of the equity on the vesting date over the amount paid, if any. Alternatively, within 30 days of the grant date, an employee may make an election under Code Section 83(b) to be taxed at the time of grant. If such an election is made, the employee recognizes ordinary income on the excess of the fair market value of the equity on the grant date over the amount paid, if any.
B. Equity Options
Equity options (including non-qualified stock options (“NSOs”) and incentive stock options (“ISOs”)) provide employees with the right to purchase company equity at a specified price (the exercise price) in the future, when the option vests.
Only C corporations may grant ISOs, and ISOs may only be granted to employees. ISOs receive favorable tax treatment if certain requirements are met (discussed below). For entities taxed as S corporations, and for grants of equity options to non-employees (such as directors or independent contractors), NSOs may still be awarded.
- Advantages to equity option awards include the following:
- The employee is generally incentivized to increase the value of the company, and equity options permit the employee to participate in the company’s growth.
- The employee eventually becomes an owner of the company.
- The employee has flexibility in electing when to exercise the option once it has vested.
- Disadvantages to equity option awards include the following:
- The employee must have sufficient cash to pay the exercise price.
- The fair market value (“FMV”) of the company on the grant date is often difficult to determine and may be subject to an approved valuation method under Code Section 409A.
- The employee receives no ownership rights at the time of grant; rather, the benefit is deferred to the date on which the employee exercises the option.
- The current owners’ holdings are diluted by the service provider’s award upon vesting and exercise.
- Taxation of Equity Options
a. Non-Qualified Equity Options
Under Code Section 83, an employee recognizes ordinary income in connection with an NSO either (1) at the time of grant if the option has a readily ascertainable FMV at the time of its grant, or (2) (more typically) at the time of exercise if the option did not have a readily ascertainable FMV at the time of its grant. NSOs are not subject to tax at vesting.
NSOs are not categorically exempt from Code Section 409A and must be structured carefully to avoid its implications.
b. Incentive Stock Options
ISOs are subject to more restrictions than NSOs, but ISOs are categorically exempt from Code Section 409A, and employees receive more favorable tax treatment under ISOs. To qualify as an ISO under Code Section 422, the option must have certain characteristics and restrictions set forth in a formal plan approved by the owners of the issuing entity.
ISOs are not subject to ordinary income taxes for employees at grant, vesting, or exercise if (1) the shares are held for both (i) one year from the date of exercise, and (ii) two years from the grant date; and (2) the holder exercises the ISO while still an employee or within three months after terminating employment. The employee defers any income tax on exercise until the shares purchased on exercise are ultimately sold.
If the shares acquired by the employee on exercise are held for the requisite time periods, then when the shares are sold, the employee only recognizes long-term capital gain treatment on the difference between the sale price and the exercise price. If the shares are not held for the requisite time periods, then the option loses its status as an ISO and is instead treated as an NSO for tax purposes.
C. Phantom Equity
Phantom equity represents an employer’s unsecured and unfunded promise to make a cash payment to a service provider at a specified time in the future, equal to the value of a specified number of company shares or units. Unlike equity options and restricted equity, phantom equity does not convey any actual ownership in the business. Therefore, a phantom equity award permits the employee to share in the company’s success without having any actual equity in the business.
- Advantages to phantom equity awards include the following:
- The employee’s compensation is tied to the financial success of the company without diluting ownership.
- The employee need not pay any amount to receive the cash benefit.
- The award is a cash payment, avoiding problems with lack of marketability generally associated with units in a closely held LLC and any issues associated with transferability restrictions.
- Little to no governance changes would need to be made to governing documents.
- Possible disadvantages to phantom equity awards include the following:
- The company must have sufficient cash flow to make a cash payment to the employee upon vesting and settlement of the award.
- Because phantom equity grants no actual ownership interest in the company, employees may not be as incentivized to contribute to the company’s growth as had they been granted restricted equity or equity options.
- Taxation of Phantom Equity Awards
There is no transfer of value when a phantom equity award is granted to an employee and thus no taxation until the phantom stock vests and is settled. There is, however, a bifurcation of tax treatment at vesting and settlement. So long as the award is exempt from or complies with Code Section 409A, there are no federal income tax consequences at vesting, but the FMV of the phantom equity award is subject to FICA taxes at vesting. At settlement, the employee recognizes taxable compensation in an amount equivalent to the value paid.
D. Profits Interest
A profits interest is an equity grant used exclusively by partnerships (or entities taxed as partnerships) that entitles the holder to a share of future profits, but not to the capital of the company.
- Advantages of a profits interests plan include the following:
- The employee is generally incentivized to increase the value of the business because the employee shares in the business’ growth.
- The employee becomes a partner at the time of grant.
- The employee need not pay any amount to receive the profits interest.
- Disadvantages of a profits interests plan include the following:
- The current owners will be diluted as to future profits of the company.
- Significant changes would need to be made to the operating or partnership agreement.
- The service provider becomes a partner and can no longer be treated as an employee for tax purposes and many employee benefit plan purposes.
- Taxation of Profits Interest
If structured appropriately, the grant of a profits interest in exchange for providing services to the company is not a taxable event. However, once the interest is granted, the employee, as a new partner, is subject to pass-through taxation on partnership income. The structure and attributes of a profits interest must be carefully set forth in the operating or partnership agreement to comply with law and qualify for tax-free treatment of the grant.
Once the equity compensation alternative is selected, the next steps for an employer are to (1) create a plan document, (2) update the company’s governing documents, and (3) ensure that the documents are in agreement. Then, the company can issue the awards and draft award agreements for each grantee.
To maintain compliance, practitioners should review the legal and tax implications above when advising clients on equity compensation. As long as the proper steps are taken, employers and employees can reap the benefits of equity compensation.