Nothing wrong about using phantom equity as compensation – Part 1
When it comes to compensating an employee with an equity grant, it’s not a perfect world considering the impact of taxation. A perfect world when granting equity compensation from a tax perspective would include at least the following:
- On the date of award, and as the award vests, the employee receives no taxable income or gain;
- On a change of control, the employee receives the full value of the equity granted – for example, there is no strike price or equity threshold subtracted from the proceeds;
- The proceeds received are taxed only in the event of a change of control, ie when the employing company is acquired, and the shareholders can cash in their equity in dollars;
- The entire payment is a long-term capital gain for the employee; and
- The employer can deduct the full amount of the payment to the employee.
This perfect tax world for stock compensation doesn’t exist, but phantom stocks can help mitigate the shortcomings of other forms of stock compensation. One of the biggest advantages of shadow equity is that it is flexible and can be adapted to many situations. Also, it can be used as a stand-alone measure to reward employees or to complement other equity grants to address their shortcomings.
To understand the benefits of shadow equity, it is useful to summarize the existing tools for providing equity compensation.
First, equity awards, such as the granting of shares in a corporation or units in a partnership, are taxable as ordinary income when the recipient is deemed to have become the owner of those shares. The employee is considered the owner for tax purposes when the equity is acquired or, in tax parlance, “is not subject to substantial risk of forfeiture”. See generally section 83 of the IRC. The amount of ordinary income is equal to the fair market value when the employee becomes the owner of the capital. At the time the employee becomes the owner of the equity, it is as if the employer makes a cash payment to the employee and the employee then purchases the equity.
Like any purchase of shares or units, a subsequent sale of these shares is taxable as a capital gain. The amount of capital gain on the subsequent sale is measured by the appreciation from the time the employee included the equity in ordinary income, which is when the employee is deemed to have purchased the equity. If the equity grant vests over time, as each part of the grant vests, that part will be taxable as ordinary income to the recipient. Similarly, when the recipient subsequently sells the shares, any appreciation measured from each of the respective vesting dates is taxable as a capital gain.
If the stock appreciates from the grant date when it vests, the recognition of the employee’s ordinary income will also be higher. To address this issue, the IRC allows a recipient to elect under section 83(b) to include the full fair market value of the award on the date of award, even if the employee will not hold the equity until it is acquired in accordance with the vesting schedule.
On the employer’s side, as the employee recognizes ordinary income, the employer is entitled to a corresponding deduction for the amount of that ordinary income, unless another specific section of the IRC, such as section 162 ( m) for public corporations paying more than $1 million, is denied. in compensation or $280,000 for “golden parachute payments,” which are limited situations. See Section 83(h). When the employee receives a capital gain on a subsequent sale of equity, the employer is not entitled to a deduction.
ISO and ONS
Stock options are another stock compensation tool. An option award is taxable in the same manner as the previous rules for stock/unit awards only if the option has a readily ascertainable value and does not qualify as an option. Incentive stock purchase under Section 421. See also Sections 83(e)(3) , 83(e)(4). In tax parlance, options that are not ISOs are called non-statutory stock options.
NSOs rarely have an ascertainable value at the time of grant and are therefore generally taxable as ordinary income each time the NSO is exercised, in an amount equal to the difference between the fair market value of the underlying stock on the date of exercise less the exercise or exercise price of the option. See Rev. Rule. 78-185. Additionally, if the exercise price is less than the fair market value of the underlying stock, the IRS may be able to characterize the grant as a deferred compensation arrangement.
In the world of stock options, ISOs are treated differently than NSOs. Specifically, stocks acquired through an ISO may benefit from long-term capital gain rates when sold in the future. However, ISOs have very specific rules, including that:
- Shares acquired by the exercise of an ISO cannot be sold until one year after the anniversary of the exercise of the option and the second anniversary of the grant date;
- The option exercise price must equal the fair market value of the underlying stock on the date of grant; and
- Only C companies can issue ISOs.
In practice, due to the nuances of the complex rules, which are not aligned with the realities of the practical world, ISOs rarely achieve the intended purpose of providing the benefit of capital gains taxation to an employee. For example, when an ISO is exercised, the difference, which is defined as the difference between the stock’s fair market value minus the strike price, is treated as an adjustment for alternative minimum tax purposes. . This generally means that the employee will have to pay alternative minimum tax at a rate of 28% on the difference, which generally motivates the employee to pay this tax by selling the stock even though the sale will be a disqualifying disposition, which in turn causes the employee to be taxed at the ordinary income rate on the margin.
Benefits of the partnership
Partnerships, including LLCs that are taxed as partnerships, can issue profit sharing, which is like a hybrid of shares and options. The employee is only entitled to appreciation in equity value from the date of grant.
When there is a subsequent change of control, the amounts due to the employee are then calculated by tracing only the appreciation since the date of allocation of the profit sharing. Generally, profit shares held for at least one year will be eligible for a long-term capital gain. See generally Rev. proc. 93-27 and Rev. proc. 2001-43.
However, please note that profit sharing by private equity firms, real estate funds, investment partnerships and venture capital firms are generally governed by Section 1061, which was added by the 2017 Income Tax Act. tax reduction and employment and, among other things, requires the employee to hold the profit interest for at least three years to receive long-term capital gain treatment.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Steve Luker is a partner in the tax practice of Moses & Singer LLP.
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