Many business owners desire to implement equity ownership programs for their employees so as to align the interests of the owner to grow the employer’s equity value with the interests of the employee for that same task. There are many programs that can be offered to employees which achieve and accomplish this goal. We generally break these programs into two forms – grants of true equity and grants of synthetic equity. Grants of real equity provide the employee with actual ownership (or ownership rights) in the employer. Thus, the employees will be actual equity holders. In contrast, programs which grant synthetic equity provide the employee with cash based bonus programs which provide benefits based upon the equity value of the employer. The selection of a particular program often depends greatly upon the form of the employer’s entity – a corporation subject to sub-chapter “C” taxation; a corporation subject to sub-chapter “S” taxation; or an LLC taxed as a partnership.
The Infographic below details the attributes of equity grants that are only available to an LLC taxed as a partnership. Summaries of forms of both equity and phantom and actual equity programs are detailed below.
Phantom Equity Programs
Phantom equity programs are cashed based bonus programs, the value of which is determined by reference to the equity value of the company to whom the grant relates. These programs are either designed as “contingent compensation” or “deferred compensation.” They are contingent compensation if payment of the promised amounts is contingent on an event that hasn’t yet occurred and may not occur. In contrast, these amounts are deferred compensation if the right to an amount is non-forfeitable, but the time, form and amount of payment are conditioned upon a future event.
Phantom stock/units is a type of equity compensation that is linked to employer stock. The recipient is not issued actual shares of stock/units on the grant date but instead receives an account credited with a certain number of hypothetical or “phantom” shares/units. The value of this account increases or decreases over time, based on the appreciation or depreciation of the employer’s stock/units and the crediting of phantom dividends. Phantom stock is taxable to the holder on the payout date.
Unlike stock appreciation rights (described below), phantom stock entitles the employee to the full value of phantom stock generally does not need to be exercised by the employee – instead the amounts are paid at the time and in the form determined as of the date of the grant the shares at the time of payout, rather than only the appreciation in value from grant to payout. In addition,
Stock Appreciation Rights
A stock appreciation right (SAR) is a contractual right which allows an employee to receive cash or stock equal to the appreciation in value of a share of employer stock from the grant date until the date the SAR is exercised. SARs differ from Phantom Stock/Units because of this built-in purchase or exercise price. SARs are customarily subject to a vesting period and, once vested, may be exercised at the election of the employee.
When exercised, SARs are customarily settled in cash, but may also be settled in stock. SARs commonly vest on a time basis rather than a performance basis. SARs are generally taxable to the holder when exercised.
Change in Control Bonus Plans
A change in control bonus plan is a plan that provides employees a cash bonus upon the sale of either the equity or substantially all the assets of the company for whom the employee provides services. These programs are typically utilized to incentive the employees to accomplish the goal of completing a sale of the employer.
EBITDA or Revenue Bonus Programs
An EBITDA or revenue bonus program is typically a program that provides an incentive the employee to increase either profits or revenue. These programs sometimes are developed as annual compensation programs or are connected to a deferred compensation program designed to defer the bonus amount to be paid at a date certain in the future.
Actual Equity Programs
Stock/Unit Option Plans
Employee stock options are a type of equity compensation that provides the employee with the right to buy employer stock at a specified exercise price at the end of a specified vesting period.
The exercise price is the fair market value of the share of stock at the time the option is granted. The vesting is commonly time-based (or, less often, performance-based). Options are exercisable for a specified exercise period after the option vests, typically for five to ten years. As discussed in more detail on the memorandum detailed as Exhibit B, stock options are classified for tax purposes either as non-qualified stock options (NQSOs) or statutory stock options. The tax treatment of stock options depends on the classification of the option.
Restricted Stock/Unit Grant Plans
Restricted stock is a grant of stock to employees that is subject to certain restrictions. On the grant date, employees become the owners of record of the shares and have voting, dividend and other stockholder rights. However, the shares are non-transferrable and subject to forfeiture until the restricted stock vests (meaning, until the restrictions lapse). Restricted stock customarily vests when there is either (or a combination of ) :
- A completion of specific time-based employment service requirements (time-based vesting).
- An achievement by the company and/or the employee of certain performance-based conditions (performance-based vesting), such as annual revenue or net income targets for the company.
If the vesting conditions are not satisfied, the shares are forfeited.
The shares are fully issued at the time of the grant. The shares ordinarily have no purchase or exercise price and provide immediate value to the grantee. Therefore, the awards have no risk of going “underwater” (this occurs when the fair market value of the stock underlying a stock option is less than the exercise price of the option). Restricted stock is considered a transfer of restricted property at the time the award is made which means that holders can elect to be taxed on the grant date under Internal Revenue Code (IRC) Section 83(b) (generally a tax-advantaged election for the holder, although not without risk due to the risk of forfeiture of the shares). If an IRC Section 83(b) election is not made, the holder is taxed when the shares vest.
Restricted Stock Units
Restricted stock units (RSUs) are awards that represent a promise to transfer shares of a company’s stock in the future if certain vesting criteria are met. The RSUs ordinarily have no purchase or exercise price. After vesting, RSUs are customarily settled in stock but may also be settled in cash. They do not represent actual ownership interests in the underlying shares.
Like restricted stock, RSUs normally are subject to time-based or performance-based vesting and are forfeited if the vesting conditions are not met. Because holders of RSUs are not the actual owners of the underlying shares, they are not entitled to dividend, voting or other stockholder rights until the RSUs vest and the shares are transferred to them. Many companies, however, accrue “dividend equivalents” on RSUs during the vesting period so that holders receive the amount (in cash or shares) that they would have received in dividends if they had been the owners of the underlying shares. Because the grant of RSUs is the grant of a promise and not a grant of restricted property, RSUs are not subject to taxation until the underlying shares vest and are delivered.
Partnership Interest Plans: Capital Interests vs. Profits Interests
Partnership interests can be divided into capital interests and profits interests. A capital interest is a partnership assets were sold at their fair market value and the proceeds distributed in a complete liquidation percentage of future profits (but not existing capital) from the partnership. partnership interest (e.g. a Unit in an LLC) that gives the owner the right to a share of proceeds if the of the partnership. A profits interest is a partnership interest that gives the owner the right to receive a
Most commonly, a profits interest (sometimes called a “profits-only” interest or “mere profits” interest) is granted to a partner in exchange for a contribution of services (often referred to as a service partner). In many cases, a service partner is an executive or senior manager at the partnership. By contrast, a capital interest is typically granted to a partner in exchange for a contribution of cash or other property (often referred to as an investor partner). Because some investor partners are also executives or senior managers, an investor partner may also be granted a separate profits interest in exchange for a contribution of services.
Unlike the owner of a capital interest, the owner of a profits interest has no current capital at risk in the venture and, usually, has no obligation to contribute funds in the future. Therefore, all that can be lost by the owner of a profits interest are profits earned after the grant date of the profits interest.
Under current IRS guidance, the owner of a partnership interest (either a profits or capital interest) cannot simultaneously be treated as an employee of the partnership. Therefore, if an employee is granted a partnership interest (either a capital or profits interest), the employee becomes a new partner in the partnership and a former employee of the partnership. This could result in adverse tax consequences for the employee.
Comparing Nonequity Interests and Equity Interests in Exchange for the Performance of Services
Stock Option Plan Design Possibilities
The Internal Revenue Code of 1986, as amended (the “Code”), generally provides for three types of stock options plans which can be designed to benefit employees. First, an employer can create and grant options to its employees under an Incentive Stock Option Plan (also referred to a Statutory Stock Option Plan). Second, an employer can create and grant options to its employees or other service providers (e.g. independent contractors) pursuant to the terms of one of two types of Non-qualified Stock Options Plans (also referred to as Non-statutory Stock Option Plan) with the difference resting on the means and timing of taxation of the benefits provided under the plan.
The first of these Non-qualified Stock Option Plans exists when the options granted to an employee have a readily ascertainable fair market value. As discussed later in this memorandum, this accelerates taxation to the employee but generally results in a greater tax benefit.
The second of these Non-qualified Stock Option Plans exists when the granted options do not have a readily ascertainable fair market value. This type of plan delays taxation but generally results in a greater tax liability to the employee. As will be discussed below, the form of the stock options which are granted to employees under a plan will often eliminate the ability of an employer to offer to its employees a Non-qualified Stock Option Plan which provides for options with readily ascertainable fair market value.
Incentive Stock Option Plans
Incentive stock options (ISOs) are options granted to an individual for any reason connected with his corporation), to buy stock in the employer corporation, or in the related corporation, and which satisfy the ISO qualification requirements. In order to satisfy these ISO qualification requirements, the plan must meet are discussed briefly below employment, by his employer corporation, or by a parent or subsidiary of the employer corporation (a “related” certain adoption requirements, grant period requirements and exercise period requirements, each of which.
First, an ISO must be granted pursuant to the terms of a written plan which is adopted by the shareholders of the company (or related company) for which options will be granted. This plan must satisfy the ISO requirements discussed in this memorandum and must indicate the number of options which can be granted pursuant to the plan, the eligibility requirements for receiving the options and not indicate that the options granted under the plan are not ISOs. Second, the plan must provide that the options can only be granted within ten (10) years of the adoption of the plan and must provide that the options must be exercised within ten (10) years from the date in which the option is granted.
Next, the plan must guarantee that the strike price of the ISO must not be set below the fair market value (FMV) of option stock as of the date in which the option is granted. Fourth, the plan and grant agreement must ensure that the ISO must be nontransferable. Fifth, it must be indicated that the options will not be treated as ISOs to the extent that the aggregate fair market value of the stock with respect to the ISOs are exercisable for the first time by any individual during any calendar year exceeds $100,000.00. Finally, the plan must require that an ISO granted to an employee who owns more than 10% of the employer, or its parent or subsidiary, must have a strike price which is at least 110% of the ISO stock’s FMV on the date of the grant and must require that such an option not be exercisable after five (5) years from the date in which the options are granted.
Neither the receipt nor the exercise of an ISO is a taxable event so long as the employee does not dispose of the ISO before the end of the required holding period. An employee satisfies the required holding period if they do not make a disposition of the share of stock acquired with the ISO before the later of: (1) the two-year period from the date of the grant of the option under which the stock is transferred; or (2) the one-year period from the date of transfer of the stock to the individual. After satisfaction of the required holding period, the employee is not taxed until they sell the underlying stock and the employee may have a capital gain at that time. However, if the ISO stock is disposed of before the expiration of the required holding period, the gain is includible in income and a portion of that gain may be ordinary income. Furthermore, the employer is not entitled to a deduction with respect to an ISO unless the stock acquired with the option is disposed of before the holding period has run. In that case, the amount of the ordinary income includible in the employee’s income is deductible by the employer.
Non-Qualified Stock Option Plans
A Non-qualified Stock Option, for federal income tax purposes, is a compensatory option that does not meet the requirements for an Incentive Stock Option, or that is granted under a plan (or offering) that does not meet the Incentive Stock Option requirements. This means an option granted to an employee or other service provider which is not an Incentive Stock Option is a Non-qualified Stock Option.
Readily Ascertainable Fair Market Value
The income tax treatment for Non-qualified Stock Options are governed by the Code section 83 rules for property transferred in connection with the performance of services. If a Non-qualified Stock Option has a readily ascertainable fair market value when it is granted, that value (less any amount that must be paid for the option) is included by the service provider as compensation income at grant. In this instance, the employee will have a taxable event upon the sale of the underlying stock obtained with the option or upon the sale or other disposition of the option, but will not recognize any gain or loss upon the exercise of the option. As the property held by the employee or service provider (i.e. either the option or the company stock) is a capital asset, any gain or loss arising from the disposition of the stock or the option will be capital in nature.
The IRS has stated that options have a “readily ascertainable fair market value” only if the option can be traded on an established market or if the value can be “measured with reasonable accuracy.” Options features with restrictions on transfer, with very long durations or which provide stock upon exercise which is restricted can very rarely be demonstrated to exhibit compliance with this test even if options are issued for a company which is listed on a widely traded public exchange. As such, it is rare for a compensatory stock options such as Non-qualified Stock Options to have a “readily ascertainable fair market value.”
Strike Price of Non-qualified Stock Options
If an option does not have a readily ascertainable fair market value, the difference between the value of the stock acquired with the option and the exercise price must be included in the employee’s gross income in the tax year in which the option is exercised. The employer granting the option has a corresponding service provider is to include the option in his or her income in the tax year in which the option is exercised. The employer granting the option has a corresponding compensation deduction for the amount included in income by the employee in the same year that service provider is to include the option in his or her income.
Take Away –
A company can create either an Incentive Stock Option Plan or a Non-qualified Stock Option Plan under which the options for the company stock may be granted to the company’s employees. Creating and implementing an Incentive Stock Option Plan provides your employees a greater tax benefit with less beneficial tax treatment for your company and with more arduous administrative requirements. In comparison, adopting a Non-qualified Stock Option Plan will also allow you to grant your employee stock options, however, the tax benefit to the employee is less advantageous. Despite this fact, such a plan is much easier to administer.