There are a number of types of instruments that an employer can issue key employees and independent contractors (employees and independent contractors are referred to collectively as “service providers” to signify that the benefit discussed applies to independent contractors as well as employees) to give the service providers a piece of the upside in the enterprise. This article will a summary of most of the popular ones, their standard terms and their tax treatment for the employer and employee or contractor.
What can be issued depends in large part on the type of entity that the employer is. There are some instruments like options that both a corporation and a limited liability company (LLC) may issue and some that only one or other may issue.
Corporations may issue incentive instruments that are geared to the value of their stock, like options and stock appreciation rights. An option is the right to purchase a share of the employer’s stock at an agreed price. The exercise price should not be less than the stock value as of the date of issuance of the option. Failure to do so will result in income inclusion to the recipient service provider under Section 409A of the Internal Revenue Code (the “Code”). That income would be able to be included in the year of receipt and annually as the spread between stock value and exercise price increases. (Treasury Regulation §1.409A-1(b)(5).) The need to value the stock of closely held employers to maintain compliance with Section 409A has created a demand for “409A appraisals” within the valuation industry. Treasury Regulation §1.409A-(b)(5)(iv)(B)(2)(iii) affords a safe harbor for an employer that bases its valuation on a good faith written valuation report.
There are two kinds of options that a corporation may issue, incentive stock options (“ISOs”) and non-qualified options (“NQOs”). The benefits of ISOs are (a) the exercise of an ISO does not result in ordinary compensation income for the option holder and (b) income, in the form of capital gain, is not recognized until the stock is disposed of. (Code Section 422(a).) If the optionee holds the stock for at least two years from the date of issuance of the ISO and at least one year from date of exercise of the ISO, the gain on the sale of the stock would be long term capital gain.
To be an ISO the option must have been issued to an employee (not an independent contractor or outside director) of an employer corporation; the option must have been issued pursuant to a plan approved by the corporation’s shareholders within 12 months of the adoption of the plan by the corporation’s board; the option may not have more than a 10 year term from the date of issuance; the option may not be transferable and may not be issued to a 10% or more shareholder (the option must have an exercise price of more than 110% of the stock’s value on the date of issuance if the option is issued to a 10% or more shareholder). (Code Section 422(b).)
Exercise of an NQO results in income for the service provider in the difference between the value of the stock and the exercise price on the date of exercise. That benefit is tempered by the inclusion of the difference between stock value and exercise price of an ISO in alternative minimum taxable income, potentially implicating the alternative minimum tax for the option holder.
A stock appreciation right (SAR) is the right of a service provider to receive a cash bonus in the amount of the stock value on the date of exercise over the stock value on the date of issuance. Exercise of the SAR may be limited to certain events or may exercisable at any time by the service provider, both employee and independent contractor. To avoid the reach of Section 409A, the SAR must be based on appreciation over the value of the stock on the date of issuance of the SAR.
Phantom stock rights and restricted stock units (RSUs) are the right to receive a cash bonus equal the value of the employer’s stock. (“A RSU provides a right to receive an amount of compensation based on the value of stock that is payable in cash, stock, or other property.” (Treas. Dec. 9716 (Apr. 1, 2015).) Because Section 409A applies to the right to receive a cash bonus, payments with respect to phantom stock rights and RSUs effectively have to be limited as follows:
(1) the service provider's “separation from service”, subject to a six-month delay requirement for separation from service of a “specified employee” (generally an officer or highly compensated employee of a public company);
(2) the date the service provider becomes “disabled”;
(3) the service provider's death;
(4) a specified time or fixed schedule specified under the plan at the date of the deferral of the compensation;
(5) a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the corporation's assets; or
(6) the occurrence of an “unforeseeable emergency.”
Grants of equity or any property (options are excluded from the term property for this purpose) to a service provider result in compensation income upon the earlier of issuance of the property or the lapse of any restrictions on the grant. (Code Section 83(a) and Treasury Regulation §1.83-3(a)(2).) The recipient service provider has the ability to include the value of the unvested equity grant in income as of the date of receipt. (Code Section 83(b).) In a start up, the election is almost always made to include the value of the equity grant in income as of the date of issuance, despite the risk that the vesting requirements might never vest, but with any gain on the sale of the equity eligible for long term capital gain treatment if the holding period of one year is met.
LIMITED LIABILITIES COMPANIES
Limited liability companies (LLCs) as well as limited partnerships and general partnerships may offer all of the incentive compensation instruments that a corporation can except for ISOs. But, LLCs may offer profits interests which are probably the best incentive compensation instruments available.
A profits interest is an interest in an LLC that by definition would yield the recipient no share of the proceeds if the LLC's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the LLC. This determination generally is made at the time of receipt of the LLC interest. (Revenue Procedure 93-27, 1993-2 C.B. 343.) The profits interest treatment is only open to interests granted for services to the LLC. The concept of a profits interest as not being includible in the recipient’s income on receipt is beneficial as the benefit is not dependent on the valuation of the interest granted, but on the assets of the LLC.
When a profits interest is granted, the LLC values its assets and sets that value as the “base value” or the “threshold amount.” Once the LLC has made cumulative distributions equal to the base value/threshold amount, the profits interest participates along with the other holders of the class of LLC interest granted. If the LLC sells an asset and recognizes long term capital gain, the profits interest holder recognizes long term capital gain as well.
Unlike an ISO in the corporate context, there is no income on grant of the profits interest (either for regular tax or alternative minimum tax purposes).
Michael Shaff joined the firm in 2011 as Of Counsel. He is chairperson of the Tax Practice Group. Michael specializes in all aspects of federal income taxation. Mr. Shaff has served as a trial attorney with the office of the Chief Counsel of the Internal Revenue Service for three years. Mr. Shaff is certified by the Board of Legal Specialization of the State Bar of California as a specialist in tax law. Mr. Shaff is a past chair of the Tax Section of the Orange County Bar Association. He is co-author of the “Real Estate Investment Trusts Handbook” published annually by West Group.
For more information about the Incentive Compensation Plans and the Tax & Estate Planning Practice at Stubbs Alderton & Markiles, LLP, contact Michael Shaff at