One of the most common issues early stage businesses face is how to structure equity compensation. In addition to the question of how much equity to provide employees, the issue presents tax, corporate and securities law compliance issues. Below is a brief overview of some of the ways equity compensation can be provided to an employee.
Plans Applicable to both LLCs and Corporations.
- Share Appreciation Right (“SAR”) Plan (sometimes referred to as a Phantom Stock Plan). Under a SAR plan, a participant could be granted the right to participate in the future growth of the entity over and above current fair market value by receiving cash equal to a percentage of such growth upon a liquidity event. (Although there are complexities under Section 409A of the Internal Revenue Code (“IRC”), the plan could also presumably provide an annual benefit equivalent to a dividend. The IRC Section 409A regulations contain fairly explicit rules which are useful in assuring that the SAR plan does not run afoul of that section’s restrictions.) Because an employee participant obtains only a right to future income (and no actual securities), there should be no securities law issues.
- Restricted Stock Units (“RSUs”). Under an RSU plan, an employee is granted a specific number of RSUs for the year. RSUs are not stock; rather, RSUs represent the unsecured and unfunded contractual promise by the employer to deliver shares of stock (or under certain plans their cash equivalent) to an employee in the future if the employee satisfies certain vesting requirements and the other terms of the RSU agreement. These vesting restrictions are generally designed to provide an incentive to the employee to remain with the employer through the vesting period. The employee is subject to tax upon the receipt of shares, the liquidity to pay taxes is generally funded through the public marketplace. Thus, privately held companies do not often use RSUs payable in stock.
- Nonqualified Option Plan. Under a nonqualified option plan, there is no tax to the recipient upon the option grant. The spread between the fair market value of the underlying units upon exercise and the exercise price is taxable to the employee at the time of exercise. Withholding at that time would be required. The Company would be required to comply with both Federal and State securities laws at the time options are granted. The most common federal exemption used by start-up companies in this context is Rule 701. With respect to state securities laws, each state is different; however, in California employers will often rely on Section 25102(o) of the California Corporations Code (“CCC”).
Plans Applicable in the Corporate Context.
- Stock Plan. Under a stock plan, the company can grant or sell vested or unvested stock to its employees. In the event of a grant of unvested shares, unless the employee makes an IRC Section 83(b) election within 30 days of the grant, the employee would be taxable as the shares vest. If the employee were to make an IRC Section 83(b) election, the spread between the price paid for the shares and the fair market value of the shares would be taxable upon receipt. If fully vested shares are granted, the employee is taxable on the spread between the price paid for the shares and their fair market value on the date of grant. The Company would be required to comply with both Federal and State securities laws.
- Incentive Stock Option (“ISO”). Unlike nonqualified options discussed earlier, ISOs generally provide for no tax to the employee either upon the grant or exercise of the option, and the employer is not entitled to a deduction for the spread at exercise. However, in many cases, employees exercising ISOs will be subject to the Alternative Minimum Tax. Again, companies issuing ISOs must comply with federal and state securities laws.
- Employee Stock Purchase Plan. Under an Employee Stock Purchase Plan, a discount of up to 15% can be granted to employees on the purchase of corporate stock. If the other requirements for such plans are met, the employee does not recognize income on the discount upon the stock purchase; rather, income is recognized only later when the shares are sold. Employee Stock Purchase Plans are generally broadly based plans covering a wide variety of employees and are not specifically targeted to senior management.
Plans Applicable in the LLC Context.
- Issuance of Profits Interest. The issuance of a LLC profits interest to employees is somewhat analogous to the SAR plan discussed previously, but involves more complexity. If an LLC were to issue profits interests to employees, there should be no tax to the employees upon grant. The employees would simply report their pro rata share of income or loss on an on-going basis. A sale of the business could produce capital gains under existing law, although there have been several attempts recently to treat so-called “carried interests” as producing ordinary income on a sale. Though the receipt of a profits interest is very tax favorable, profits interests create a level of corporate and tax complexity which may be undesirable. For example, an employee with a profits interest becomes a partner rather than an employee for income tax purposes. Additionally, a seasoned partnership tax expert must be consulted in connection with the drafting of the necessary documents.
- Issuance of Capital Interest. The issuance of a capital interest is a taxable event requiring income recognition and is rarely used as a compensation tool for this reason.
Because of the business and legal risks involved in providing equity compensation, an attorney should be consulted very early in the process. If your business is considering issuing equity compensation, we invite you to contact Mr. Badyal by phone at 619-500-4540 or by email at aman@badyallaw.com.
IRS CIRCULAR 230 NOTICE: To the extent that this message concerns tax matters, unless expressly stated otherwise, it is not intended to be used and cannot be used by the reader for the purpose of avoiding tax penalties that may be imposed by law. For more information about this notice, see http://www.irs.gov/pub/irs-utl/pcir230.pdf
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