http://biz taxbuz z .com/compensating-employees-with-equity/ May 21, 2013

Compensating Employees with Equity | BizTaxBuzz byTrevor Crow

25thMarchCompensating Employees with EquityPosted by Trevor Crow

Alex has been the top salesman at Big Widgets Inc. for the past 3 years. The two founders of BigWidgets, Barb and Cole, want to reward Alex and give him an incent ive to cont inue working for thecompany, so they decide to issue Alex shares in the company. Alex is grateful for his newownership interest in the company and Barb and Cole are excited about Alex’s future contribut ionsto the company. Everyone is happy, right?

Maybe not. Alex was happy unt il his accountant told him he has to pay tax on the value of theshares he received. Alex says that can’t be right because “I haven’t realized any gain.”

Alex received stock in a company that he can’t sell (or use to pay his taxes). Yet, he has incomeequal to the value of the stock. In other words, he has a tax bill but no money to pay the tax.

For tax purposes, the issuance of equity (e.g., stock or membership interests in an LLC) to anemployee is t reated as if (1) the employer paid cash to the employee, and (2) the employee usedthe cash to buy the equity f rom the company. Accordingly, the cash payment f rom the employerto the employee is t reated as compensat ion and taxed at ordinary income rates, and the employeris ent it led to a tax deduct ion for this amount. The general rule that an employee is taxed oncompensat ion applies regardless of whether the compensat ion is in the form of a paycheck orequity. Many employees have the misconcept ion that this equity award is a non-taxable gif t . Unfortunately, the tax code does not allow an employer to make gif ts to employees. The IRS callsthis compensat ion.

Is there a way to structure this t ransact ion for a dif ferent result? There are a few possible choicesthat defer the tax owed over mult iple years, such as restricted stock and stock opt ions, but everychoice has advantages and disadvantages. The following is an explanat ion of a few alternat ives:

Options

There are many rules surrounding the issuance of stock opt ions that are outside the scope of thisart icle, but many companies issue opt ions that meet certain requirements called incent ive stockopt ions (or “ISOs”). Assume that the company issues 1,000 incent ive stock opt ions to Alex withan exercise price of $1.00 each. Here, there is no income tax upon the grant of the ISO to Alexand no tax when Alex exercises the ISO. Alex is only taxed when he sells the stock in the future onthe amount that his sales price exceeds the exercise price. The downside of this alternat ive is thatAlex has to pay $1,000 to exercise his opt ion.

Restricted Stock

The company could issue shares to Alex subject to a vest ing schedule over 3 years with 1/3rd ofthe shares vest ing each year as long as Alex remains employed by the company. Here, Alex wouldpay tax on 1/3rd of the value of the shares each year as they vest. The potent ial problem with thisarrangement is that Alex pays tax on the value of the equity when it vests at ordinary incomerates. Thus, if the stock appreciates between the grant date and when it vests, Alex pays ordinary

income rates on the full value, including the appreciat ion.

Cash instead of Stock

A simple solut ion would be for the company to pay the equivalent value of the shares in cashcompensat ion to Alex. Alex would st ill pay tax on this amount, but he would have the cash to paythe tax bill when it comes due. However, this arrangement defeats the purposes of grant ing equitycompensat ion (i.e., with cash compensat ion the company must use cash to pay Alex and Alex hasno ownership to incent ivize him to perform and remain employed with the company).

Profits Interest (If an LLC)

When a company is an LLC instead of a corporat ion it may grant what is called a prof its interest . Aprof its interest is one that grants ownership in any increase in value of the company, but not in theownership of the current value of the company. A prof its interest is not taxable upon grant. Theowner of a prof its interest is taxed when and if the company allocates income to the member inthe future.

Bottom Line: An employee or potent ial employee should understand the tax consequences ofreceiving equity compensat ion before agreeing to a part icular arrangement. Otherwise, theemployee may get more than he or she bargained for when it comes t ime to pay taxes.