Employee Equity Options
This is the last article in our series focusing on employee equity considerations for closely-held private companies. If you haven’t already read our article on employee equity tax implications, we recommend you do so before reading this article - as the employee equity options shared here are driven by certain tax concerns. You can find that article here.
1. Issuance of Equity Without Payment. As we discussed in our previous article, the fair market value of equity issued to an employee without payment (a gift) is compensation to the employee taxed at the employee’s ordinary income tax rate. In some cases, it may be preferable to gift equity to an employee notwithstanding the tax impact. If this is the direction you choose, either (i) the employee can accept the equity and the tax burden, or (ii) the company can bonus the employee up to provide the employee with cash to cover the tax burden.
2. Issuance of Equity With Payment. If the employee pays fair market value for their equity, the taxable income issue is alleviated. If the employee cannot afford to pay for the equity all at once, the employee can be allowed to buy the equity in tranches over time (although this may require a valuation of the equity at the purchase of each tranche) or the company can finance such purchase.
3. Gift of Equity to Family Members. If the employee is a family member of an owner, such owner can potentially make a tax-free gift of the owner’s equity to such family member. This can be accomplished by the owner making a gift of equity either (i) of a value that is less than the annual gifting limit (currently $15,000) or (ii) by filing a gift tax return if the value is in excess of the annual gifting limit (in which case, the value of such gift will reduce the owner’s lifetime gift and estate tax exemption).
4. Profits Interests. Profits interests are an equity compensation tool that are unique to companies taxed as a tax partnership (LLCs and limited partnerships). Profits interests avoid the taxable income issue because they are an interest in the future profits and appreciation of the assets of the company only, and not the current value of the company. Consequently, profits interests can be issued to an employee tax-free, provided that the profits interests meet certain safe harbor requirements under the Internal Revenue Code. An additional benefit of profits interests for the owners are that the employee will not participate in distributions until the owners have been returned the value they have built in the company up to the time the profits interests are granted. Disadvantages of profits interests are that the employee is unlikely to realize a monetary benefit from the profits interest for some time (often a sale of the company), and the employee can no longer be a W-2 employee of the company. Profits interests are typically subject to vesting, forfeiture, or buyout if the employee leaves the company, and have limited voting rights.
5. Phantom Equity. Phantom equity (also sometimes called synthetic equity) is a contractual right to receive equity-like payments, but it is not actually equity. A phantom equity agreement or phantom equity plan is used to provide an employee with a contractual right to receive future payments that are aligned with the value of the company – for example, at retirement or upon the sale of the company. Phantom equity avoids the taxable income issue because it has no current value to the employee and because all payments to the employee will be W-2 wages taxed as ordinary income. Like profits interests, phantom equity can be made subject to vesting, forfeiture, or buyout if the employee leaves the company, and also typically has no voting rights. Overall, phantom equity can be a flexible structure, is easy to implement and unwind, and allows the employee to remain a W-2 employee of the company. The disadvantages are that the employee will be taxed at ordinary income on all phantom equity payments and, as phantom equity is not “true” equity, that may discourage some employees who are seeking ownership of the company.
6. Non-Qualified Stock Options. A stock option grants an employee the right to buy equity in the company at a set price (the “grant price”) within a fixed period of time. A non-qualified stock option is a stock option where the employee will pay ordinary income tax on the difference between the grant price and the fair market value of the equity at the time the employee exercises the option (i.e., the compensation from the option). This affords the employee to potentially acquire company equity at a discounted price if the grant price is lower than the fair market value. Like profits interests and phantom equity, stock options can be made subject to vesting and forfeiture if the employee leaves the company.
7. Profit-Sharing Plans. Although not equity or equity-like, profit-sharing plans can be an effective tool to align an employee’s compensation to the performance of the company and should be considered as an alternative to issuing equity.
Note that, in several of the options discussed above, a determination of the current fair market value of the equity of the company is required. This may require a formal valuation of the equity of the company. Please consult with your CPA and attorney to determine if a formal valuation will be required.
