Taxation of Equity-Based Compensation

02 Feb 2016

In order to attract and retain staff in the competitive talent marketplace, many companies will now need to offer their employees equity compensation along with traditional salaries. How a business compensates their employees with equity depends largely on the structure of their business, whether organized as a Corporation or a Partnership (LLC). Companies need to be aware of the many different opportunities for equity based compensation for their key employees and the tax effects of issuing such alternative compensation on their business.

Corporations & LLCs Taxed as Corporations

With an LLC taxed as a corporation, the impact on a business would be the same as that of a traditional corporation. Corporations generally have 3 different methods of compensating employees.

Incentive (Qualified) Stock Options (ISO) – ISOs are typically offered to executive level employees and have significant restrictions on their exercise and grant. These options do not offer any corporate level deduction for the company and as such do not have any tax impact, upon grant, to the employee.

Non-Qualified Stock Options (NQSO) – NQSOs are more common options that can be granted to both employees and other service providers. These options will have a strike price (how much the shares will cost the employee) and often an expiration date. The difference between the strike price and the value of the shares represents the taxable portion of the grant, known as the bargain element. Neither the corporation nor the employee recognizes a taxable transaction on grant; the taxable event occurs upon exercise. The difference between the option strike price and value when exercised represents compensation to the employee and a compensation deduction for the corporation.

Restricted Stock/Restricted Stock Units – Restricted stock can be considered the sister of ISOs. Restricted stock refers typically to shares awarded to an executive level employee. The shares are often subject to vesting schedules, with the employee losing any shares that haven’t been vested. The employee will recognize income when the shares vest and are no longer subject to forfeiture; the company will recognize a deduction at the same time. There are some legal differences in contractual nature between restricted stock and restricted stock units; however, their tax treatment is mostly the same.

Partnerships & LLCs Taxed as Partnerships

Unless an LLC elects to be treated as a corporation, the entity will default to be treated as a partnership. In early startup years, a partnership benefits owners since the business losses will pass through to their personal tax returns, allowing them to potentially take these losses against other income. Additionally, many investors enjoy the benefits related to a single layer of taxation rather than the additional tax costs of an incorporated structure. Partnerships differ greatly in both the nature and planning opportunities for equity based compensation. There are 2 primary methods for equity based compensation in a partnership.

Capital Interest – A capital interest refers to a grant of partnership equity to an employee that includes a right to the equity of the business prior to the date of the grant. Said another way, the employee gets to share in a percentage equal to the grant of all of the value of the business prior to the grant. A capital interest is determined by the liquidation rights on the date of the grant – if the employee is entitled to assets upon liquidation, then it is a capital interest.

A capital interest will give rise to a deduction to the business equal to the value of the newly created capital account, and the employee will recognize ordinary income equal to the deduction taken by the business.

Profits Interest – The IRS broadly and foolishly defines a profits interest as “any interest other than a capital interest”. In practical terms, a profits interest represents an interest in the future appreciation of a partnership from the date of grant. From the date of the grant, the employee will share in the profits and losses of the partnership equal to his percentage grant and begin to create a capital account which represents the appreciation of the partnership from the date of grant. An important feature of a profits interest is that the grantee has no liquidation rights on the grant, only on the future appreciation.

Given that at the date of the grant the employee is not being given anything other than a right to future growth, the business will not recognize a deduction for the grant and the employee will not have any income.

Different business structures allow for different methods of rewarding employees with equity compensation, each with different tax effects for the businesses. On top of compensating employees for their hard work, equity based compensation can often align the goals of the business with the goals of the employees to help maximize the value of the entity and to encourage growth. With the multitude of options, it is important for all businesses to make sure they understand their options and how these different forms of equity compensation will affect their taxable situation.

This article was also featured in our newsletter Bottom Line Vol. 13