Equity-Based Compensation for Corporations, Partnerships and LLCs

St. Louis Bar Journal
vol. 66, no. 4 / Spring 2020 Publications

Republished with the permission of the Bar Association of Metropolitan St. Louis and the St. Louis Bar Journal

Corporations, partnerships and limited liability companies (“LLCs”) can choose from a variety of equity-based compensation awards to recruit and retain talented service providers and to motivate those individuals to increase the value of the organization. Equity-based compensation includes any compensation paid to an employee, director, contractor, consultant or other service provider that is based on the value of a specified stock of a corporation or unit of a partnership or LLC.[1] Before a company can award equity-based compensation, it must select the appropriate type of award.

The first step in selecting the appropriate type of equity-based compensation award depends on the type of organization, such as an LLC or a corporation, and how it is structured. Specifically, for equity-based compensation, you need to know how an organization is capitalized and how the organization (or organizations) is taxed to determine what types of awards may make sense.

As described in more detail below, the awards that are commonly used by a corporation operate differently than those typically used by a partnership or LLC.[2] While there is no “best” type of equity-based compensation, we recommend considering (i) what types of awards are common for the applicable type of organization, (ii) the key tax provisions that apply to the common awards; and (iii) the intended tax treatment for the organization and the service provider.[3]

1. Common Awards by Corporations.

For corporations, the common award types are: (1) stock options, (2) restricted stock, (3) phantom stock (also referred to as a restricted stock unit or performance stock unit), and (4) stock appreciation rights (“SARs”). These common corporate award types are listed below with a description and example to compare the basic terminology and economics of the awards. For simplification purposes, the examples listed below each involve a hypothetical corporation that makes an award to a service provider on January 1, 2020, when the fair market value of the corporation’s common stock is $10 per share.  Each example considers an award of, or based on, either 100 shares or the $1,000 represented by those shares’ value.  The examples each assume that the award “vests,” meaning that it is no longer subject to substantial risk of forfeiture, on January 1, 2024, at which time the hypothetical corporation’s common stock is worth $15 per share ($1,500 for 100 shares).

Corporate Award Description

Corporate Award Example

Stock options:

When a corporation grants a stock option, it offers the recipient a right to purchase a set number of shares of stock at a defined purchase price, known as an “exercise price,” subject to vesting conditions. The exercise price is typically equal to the fair market value of the corporation’s common stock on the date of grant.

Assume the hypothetical corporation grants stock options on January 1, 2020 with a fair market value exercise price of $10 per share that can be exercised if the recipient remains employed through January 1, 2024. Upon exercise, the recipient can purchase the 100 shares for $10 per share, even if the shares are then worth $15 per share; a discount worth $500.

Restricted stock:

When a corporation grants restricted stock, it awards the recipient a specified number of shares of the corporation’s stock, subject to vesting and forfeiture conditions.

Assume the hypothetical corporation grants 100 shares of restricted stock on January 1, 2020 that will vest if the restricted stock award recipient remains employed through January 1, 2024. Upon vesting, the stock award recipient owns 100 shares then worth $15 per share.

Unlike the stock options, the recipient does not have to pay an exercise price for the restricted stock. The recipient of restricted stock gets to keep the “full value” of the shares worth $1,500.

Phantom stock, also referred to as a restricted stock unit (“RSU”) or performance stock unit (“PSU”):

When a corporation grants phantom stock, it gives the recipient the right to receive a payment (in cash or shares) equal to the value of a specified number of shares of the corporation’s stock, subject to specified vesting conditions. The grant is an unsecured and unfunded promise by the corporation.

Assume the hypothetical corporation grants 100 shares of phantom stock on January 1, 2020 that will vest (and be immediately settled) if the phantom stock award recipient remains employed through January 1, 2024. Upon vesting, the award recipient will receive a payment with respect to the 100 phantom shares then worth $15 per share; a cash payment of $1,500.

Instead of buying or receiving shares, the recipient of phantom stock receives the stocks’ cash equivalent when settled.

Stock appreciation rights (“SARs”):

When a corporation grants SARs, it gives the recipient the right to receive a cash payment equal to the value of a specified number of shares of the corporation’s stock in excess of a specified strike price. The strike price is typically equal to the fair market value of a share of the corporation’s common stock on the date of grant.

Like stock options, SARs only provide the value of any increase in the stock price. However, the recipients of SARs typically receive cash; whereas, the recipients of stock options receive stock upon exercise.

Assume the hypothetical corporation grants 100 SARs on January 1, 2020 with a fair market value of $10 per share that will vest (and be immediately payable) if the award recipient remains employed through January 1, 2024. Upon vesting, the award recipient will receive a payment equal to the appreciation on the 100 shares (then worth $15 per share); a cash payment of $500.

Common Awards from Partnerships / LLCs.

For partnerships and LLCs, the common award types are: (1) profits interests, (2) phantom equity, and (3) unit appreciation rights.  Partnerships and LLCs may also consider granting a capital interest (also referred to as a unit or restricted unit), or an option to purchase units; however, these two types of awards are typically less favorable as compared to the three other common awards for partnerships and LLCs. For simplification purposes, the examples listed below each involve a hypothetical LLC, taxed as a partnership, that makes an award to a service provider on January 1, 2020 when the fair market value of the LLC’s assets are worth $100,000, and 1% of the LLC’s assets are worth $1,000. The examples each assume that the award “vests,” meaning that it is no longer subject to substantial risk of forfeiture, on January 1, 2024, at which time the hypothetical LLC’s assets are worth $150,000, and 1% of the LLC’s assets are worth $1,500.

LLC Award Description

LLC Award Example

Profits Interest:

When a partnership or LLC grants a profits interest, it awards the recipient a right to share in the future profits and appreciation in value of the entity after the date of grant.

As a potentially major downside to granting a profits interest, an employee who receives a profits interest is no longer considered an employee for tax purposes. Instead, the profits interest holder is subject to the complexities of being a partner or LLC member, including receiving a Schedule K-1, instead of a Form W-2.

Assume the hypothetical LLC grants a 1% profits interest on January 1, 2020 (with a right to 1% of all future profits and growth) that will vest if the award recipient remains a service provider for the LLC through January 1, 2024. If the LLC had generated no profits or losses during the vesting period, then the profits interest would be worth 1% of the appreciation in the organization’s assets (1% of the difference between $150,000 and $100,000); an award worth $500. If the LLC had generated operating profits, the LLC would allocate profits and make distributions consistent with the LLC’s operating agreement.

Phantom Equity:

When a partnership or LLC grants phantom equity, it awards the recipient a right to receive a cash payment equal to the value of a specified number of units of the LLC or partnership, subject to specified vesting conditions.

Assume the hypothetical LLC grants phantom equity that mimics a 1% capital interest on January 1, 2020 that will vest (and be immediately payable) if the award recipient remains employed by the LLC through January 1, 2024. The phantom stock award will be worth 1% of the organization’s assets (i.e., 1% of $150,000) when vested. Instead of being subject to the complexities of being an LLC member, the recipient of the phantom stock award receives a cash payment of $1,500, equal to the value of the 1% capital interest.

Unit Appreciation Rights:

When a partnership or LLC grants unit appreciation rights, it awards the recipient a right to receive a cash payment equal to the appreciation of a specified number of units of the LLC or partnership subject to specified vesting conditions.

Assume the hypothetical LLC grants unit appreciation rights on a 1% capital interest to on January 1, 2020 with a fair market value of $1,000 that will vest (and be immediately payable) if the award recipient remains employed through January 1, 2024. Upon vesting, the award recipient will receive a cash payment of $500, equal to the appreciation on the 1% capital interest (i.e., 1% of the difference between $150,000 and $100,000).

Restricted capital interests, also referred to as a restricted unit:

When a partnership or LLC grants a restricted capital interest or restricted unit, it awards the recipient a right to the distribution of a portion of the proceeds upon the LLC’s complete liquidation, subject to vesting and forfeiture conditions. A capital interest holder is subject to the complexities of being a partner or LLC member.[4]

Assume the hypothetical LLC grants a 1% capital interest on January 1, 2020 (with a right to 1% of any liquidation proceeds) that will vest if the award recipient provides services to the LLC through January 1, 2024. Upon vesting, the recipient’s capital interests will be worth $1,500 (i.e. 1% of the organization’s assets when vested, $150,000). However, the capital interest recipient will be subject to the complexities being an LLC member and will not receive a cash payment until the capital interest is sold.

Options to purchase capital interests:

When a partnership or LLC grants a compensatory option, it offers the recipient a right to purchase capital interests at a specified exercise price during a specified period. The exercise price is typically equal to the fair market value of the capital interests on the date of grant. An employee who exercises the option receives a capital interest and is then subject to the complexities of being a partner or LLC member.

Assume the hypothetical LLC grants an option to purchase a 1% capital interest on January 1, 2020 with a fair market value exercise price of $1,000 that can be exercised if the award recipient remains employed through January 1, 2024. When the option is exercised, the award recipient will pay $1,000 for a capital interest then worth $1,500, (a discount of $500). The award recipient will be subject to the complexities being an LLC member and will not receive a cash payment until the capital interest is sold.

In the above hypotheticals, we simplified the awards by treating the last day of a four-year vesting period as the “settlement” date when the award recipient receives a payment in cash or shares. In practice, the settlement date is determined based on a separate set of conditions and often does not align with the end of the vesting period, especially for awards settled in cash. An award “vests” when it is no longer subject to a substantial risk of forfeiture, like four years of service in the above hypotheticals, and the award recipient has a right to a payment in cash or shares. However, a typical settlement date would be a liquidity event, such as the sale of an organization, when the organization can use the sale proceeds to make cash payments to award recipients to settle the awards.

2. Key Tax Considerations

When selecting an appropriate equity-based compensation award, an organization should consider the impact of Sections 409A and 83 of the Internal Revenue Code of 1986, as amended (the “Code”). Code Section 409A applies to equity-based compensation that is deemed or otherwise results in deferred compensation that is earned in one year, but paid in another year.  Specifically, when a corporation awards stock options, SARs, or phantom stock, or when a partnership or LLC awards phantom equity, unit appreciation rights, or options, the award should be designed to be exempt from or to comply with Code Section 409A. By contrast, equity-based compensation awards of property are subject to Code Section 83 and are generally not considered deferred compensation subject to Code Section 409A.  Specifically, when a corporation grants restricted stock, or when a partnership or LLC grants a profits interest or a capital interest, the award is considered property subject to Code Section 83.[5]

Primarily Consider
Code Section 409A

Primarily Consider
Code Section 83

Common Awards from Corporations

Stock options
Stock appreciation rights
Phantom stock (RSU / PSU)

Restricted Stock

Common Awards from Partnerships / LLCs

Phantom equity
Unit appreciation rights Options

Profits Interest
Capital Interest (Units)

When an organization grants an award subject to Code Section 83, it should consider whether the employee (or other service provider) should be permitted to make a Code Section 83(b) election (“83(b) election”).[6] An 83(b) election must be made within 30 days of the date of grant to make the applicable award subject to taxation on the date of grant. Note, if an 83(b) election is made and the award is subsequently forfeited, the employee will not be able to recover the taxable income recognized as a result of the 83(b) election.

When considering Code Section 409A, the type of award will dictate whether the award should be designed to: (1) fit within an exemption, or (2) be designed to comply with the requirements. When granting options or appreciation rights, the organization can generally design the award to be exempt from Code Section 409A by establishing an exercise or strike price of at least fair market value of the organization’s common stock or common equity units on the date of grant. When granting phantom stock or phantom equity, the organization should design the award to comply with the requirements of Code Section 409A, including permissible payment events, restrictions on funding, requirements for deferral elections, and other applicable requirements. If an award subject to Code Section 409A does not qualify for an exemption and fails to comply with Code Section 409A requirements, then the employee (or other service provider) will be subject to acceleration of income and an additional 20% income tax. However, the careful drafting of awards can typically avoid these draconian adverse tax consequences without interfering with the organization’s compensation objectives.

3. Tax Comparison Chart for Recommended Common Awards

The “right” type of equity-based compensation award should depend, in part, on the intended tax treatment for the employee (or other service provider) and the granting organization.  The following chart is intended as a reference tool to identify when the taxes will be payable by the employee and potentially deductible by the organization: (1) taxable when the award is granted; (2) when the award vests and is no longer subject to a substantial risk of forfeiture; (3) when the award is exercised or settled in exchange for value (e.g., cash or equity); (4) when any future value is received upon the subsequent sale of shares or other distributions; and (5) if the organization should expect to receive a tax deduction with respect to the award.

Type of Organization:

Common Award Type

(1) Taxable on Grant

(2) Taxable on Vesting

(3) Taxable on Exercise or Settlement

(4) Taxable on Sale of Share or Other Distributions

(5) Tax Deduction for Organization

Corporation:

Non-qualified stock options (“NQSO”)

Generally not taxable to employee on grant.

No, not taxable to employee on vesting.

Ordinary income on the “spread” (i.e., the excess of the fair market value when exercised over the exercise price).

Long- or short- term capital gain (depending on how long the shares are held) on the appreciation since the exercise.

Deduction equal to amount of ordinary income recognized by employee upon exercise.

Corporation:

Incentive stock option (“ISO”)

Generally not taxable to employee on grant.

No, not taxable to employee on vesting.

No, unless Alternative Minimum Tax (AMT) applies.

Taxable to employee upon sale of share. Capital gain or ordinary income, depending on how long the shares are held.

No deduction unless employee has ordinary income recognized upon sale of shares.

Corporation:

Restricted stock

Not taxable on grant unless employee timely files an 83(b) election within 30 days of grant.

Ordinary income on fair market value less any amount paid if employee timely files an 83(b) election.

Ordinary income on fair market value less any amount paid, except if employee timely filed an 83(b) election at grant.

Not taxable on vesting if employee timely filed an 83(b) election.

Not applicable.

Long- or short- term capital gain (depending on how long the shares are held) on the appreciation since grant or vesting, depending on 83(b) election.

Deduction equal to ordinary income recognized by employee (at either grant or vesting, depending on 83(b) election).

Corporation:

Phantom stock (also referred to as RSU or PSU)

No, not taxable to employee on grant.

No federal income tax on vesting, but subject to FICA tax.

Ordinary income recognized at settlement equal to amount of cash or fair market value of stock received in settlement.

If stock-settled, then long- or short-term capital gain (depending on how long the shares are held) on the appreciation since settlement.

Deduction equal to amount of ordinary income recognized by employee.

Corporation:

Stock appreciation rights (“SARs”)

No, not taxable to employee on grant.

No, not taxable to employee on vesting.

Ordinary income recognized equal to amount of cash received upon settlement.

Generally not applicable.

Deduction equal to amount of ordinary income recognized by employee.

Partnership / LLC:

Profits interest

Profits interest should be designed to have no value on grant; consider a protective 83(b) election.[7]

Not taxable on vesting if profits interest holder timely filed an 83(b) election.

Not applicable.

Long- or short-term capital gain (depending on how long the profits interest are held) on the distributions with respect to profits interest.

Generally no deduction for organization on valid profits interest.

Partnership / LLC:

Phantom equity

No, not taxable to employee on grant.

No, not taxable to employee on vesting.

Ordinary income recognized equal to amount of cash received.

Not applicable.

Deduction equal to amount of ordinary income recognized by employee.

Partnership / LLC:

Unit appreciation rights

No, not taxable to employee on grant.

No, not taxable to employee on vesting.

Ordinary income recognized equal to amount of cash received upon settlement.

Not applicable.

Deduction equal to amount of ordinary income recognized by employee.

 

[1] The IRS provides useful background information on equity-based compensation in its audit techniques guide, available online here: https://www.irs.gov/businesses/corporations/equity-stock-based-compensation-audit-techniques-guide.

[2] Note, an LLC will generally be taxed as a partnership by default; however, an LLC can elect to be taxed as a corporation by filing Form 8832 with the IRS. For purposes of this article, we assume that the LLC is taxed as a partnership, rather than a corporation.

[3] We also note that there are other applicable governance, accounting, and securities considerations; however, those considerations are outside the scope of this article.

[4] The holder of a restricted capital interest (who does not file an 83(b) election) should not be considered a partner or LLC member until the capital interest vests, consistent with the general principle that the service provider does not own the interest until it vests.

[5] Property awards subject to Code Section 83 are generally not considered deferred compensation subject to Code Section 409A; however, if these awards contain a deferral feature they could become subject to Code Section 409A. If the right to payment may be deferred to a subsequent taxable year, these awards should also be designed to be exempt from or to comply with Code Section 409A.

[6] For the IRS sample 83(b) election, see Rev. Proc. 2012-29. An organization will typically give the service provider a form 83(b) election that the service provider may file with the IRS. If the service provider decides to do so, the 83(b) election must be filed with IRS within 30 days of grant. The organization should require the service provider to return to the organization a copy of any 83(b) election the service provider files with the IRS.

[7] Rev. Proc. 2001-43 (the vesting of a profits interest does not constitute a taxable event if an 83(b) election has been made provided: (1) the profits interest meets the three safe harbors under Rev. Proc. 93-27 are met; (2) the holder is treated as a partner or LLC member from the grant date; (3) the holder takes into account the distributed share of the organization’s income, gain, loss, and deduction associated with the profits interest from the grant date; (4) the organization (nor its partners or LLC members) do not take a compensation deduction for the value of the profits interest.

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