For both established companies and new companies, it is often essential to allow key employees to participate in the company’s future growth and profitability through equity ownership. This helps align the interests of ownership and key employees. Equity compensation can be more affordable from the employer’s standpoint because the employee generally only benefits if there is future growth and profitability. From the employee’s perspective, it is beneficial because it allows employees to reap the rewards of their efforts. Corporations, limited liability companies, and partnerships can all issue equity compensation awards.
Traditionally, stock options have been the most common form of equity compensation. There are two types of options: (i) incentive stock options (which can only be issued by corporations) and (ii) nonqualified stock options. With incentive stock options, the employee may be able to defer taxation until the stock is actually sold and also may be able to obtain capital gains tax treatment. With nonqualified stock options, the employee has ordinary taxable income upon exercise (not sale) but the employer receives a corresponding tax deduction. Corporations, partnerships, and limited liability companies may issue nonqualified stock options. Importantly, regardless of the type of option or entity, the exercise price must be equal to or greater than the fair market value of the stock on the date of grant.
Another form of equity compensation is restricted stock. Restricted stock is granted to an employee subject to a vesting schedule. As the stock vests, the employee has taxable income equal to the fair market value of the stock at the time of vesting. The employer receives a corresponding tax deduction. For partnerships and LLCs taxed as partnerships, restricted profits interests grants have become very popular. If properly structured, the employee does not have taxable income with respect to the profits interests either on the date of grant or vesting. The employee only has an interest in the company’s future profits and has taxable income only to the extent of future profits.
Finally, another alternative is a nonqualified deferred compensation plan where the eventual payout is based on “phantom stock” appreciation. In essence, this is an unsecure contractual promise by the employer to pay monies to the employee at a later date such as upon a change in control. The payout is based on the appreciation in value of the phantom stock awarded which is designed to mirror the value of actual stock or interests. The payout constitutes ordinary income for the participant and the employer receives a corresponding tax deduction.
The foregoing is intended to be a brief summary of equity compensation alternatives. Additional analysis would be necessary for an employer to select an appropriate alternative for a given situation. We would be happy to assist with such analysis.