Equity Compensation Alternatives for Corporations and LLC's

By: Jim Dossey, MS, MBA, JD

Equity incentives are an important component of small company compensation plans. First, equity provides an alternative form of compensation for employees during cash lean startup years. Equity also aligns financial goals of the employee to the company’s financial goals. Finally, equity can be used as “golden handcuffs” to keep key employees working for the firm long-term.

The charts below describe several alternative forms of equity compensation available for Corporations and LLC’s and the tax impact for the recipient and the entity.

Corporations

Name

Description

Tax Impact

Incentive Stock Options (ISO)

Only available for employees

For recipient:

  • Employee only taxed when they sell the stock, possibly at capital gains rates

For Corporation:

  • No deduction

Non-Statutory Stock Option (NSO)

Available to anyone, including employees, contractors, etc.

For recipient:

  • No income tax upon grant
  • Ordinary income on exercise equal to the excess of the fair market value of the interests on the date of exercise and the exercise price (i.e., fair market value on the date of grant)
  • When the recipient sells the interest, short- or long-term capital gain on the difference between the amount realized on the sale and the tax basis in the interests (exercise price, plus the amount of income recognized at the time of exercise)

For Corporation:

  • Deduction for amount of income recognized by recipient on exercise date

Phantom Stock; Stock Appreciation Rights (SAR)

Bonus awards that mimic equity

Simply a promise to pay to the recipient a bonus in the future (based on a triggering event) equivalent to the value of the stock of the Corp or the increase in value over time.

Recipient can participate in financial rewards of ownership w/o voting and other equity rights; also does not dilute current member's interests

For recipient:

  • If properly structured under Section 409A of the Code, employee is subject to tax when income is received under the arrangement

For Corporation:

  • The Corp receives a deduction at the time of payment

Limited Liability Companies (LLC)

Name

Description

Tax Impact

"Capital Interest"

A capital interest is an interest that entitles the holder to share in the proceeds if the LLC's assets are sold at fair market value and the proceeds are then distributed in a complete liquidation of the LLC immediately after the interest is granted (Rev. Proc. 93-27).

The recipient has a grant date economic right in the underlying capital of the LLC, as well as its profits and losses on a going forward basis.

For recipient:

  • Treated as compensation at time of grant in amount of grant, less any amount paid for the interest
  • If subject to substantial risk of forfeiture (i.e. restricted capital interest), then taxable when the interest vests, unless recipient timely makes a 83b election
  • Capital gains treatment when recipient sells interest

For LLC:

  • Company can deduct compensation as business expense, which is allocated out to LLC members

"Profits Interest"

Similar to "capital interest", except that the recipient only has a share in the future profits and appreciation in value of the LLC following the date of grant. à Prior capital interest holders are cashed out first upon liquidation

Can be vested or unvested, similar to stock options.

Original interest owners have Series A units; subsequent profit interest owners have Series B units. Valuation before each Series is created to document value of prior Series.

For recipient:

  • No value transferred at grant, so no compensation; best practice is to still have a $0 83(b) election
  • Capital gains treatment on sale

For LLC:

  • No deduction

see Rev. Proc. 93-27

see Rev. Proc. 2001-43

Phantom Units; Equity Appreciation Rights

Bonus awards that mimic equity

Simply a promise to pay to the recipient a bonus in the future (based on a triggering event) equivalent to the value of the membership interest of the LLC or the increase in value over time.

Recipient can participate in financial rewards of ownership w/o voting and other equity rights; also does not dilute current member's interests

For recipient:

  • If properly structured under Section 409A of the Code, employee is subject to tax when income is received under the arrangement

For LLC:

  • The LLC receives a deduction at the time of payment

see IRC 409(a)

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