Compensating Employees With Equity


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An employee or potential employee should understand the tax consequences of
receiving equity compensation before agreeing to a particular arrangement. Otherwise, the
employee may get more than he or she bargained for when it comes time to pay taxes.

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Compensating Employees With Equity

  1. 1. May 21, 2013Compensating Employees with Equity | BizTaxBuzz byTrevor Crow25thMarchCompensating Employees with EquityPosted by Trevor CrowAlex 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 incentive to continue 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 contributionsto the company. Everyone is happy, right?Maybe not. Alex was happy until 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 treated as if (1) the employer paid cash to the employee, and (2) the employee usedthe cash to buy the equity from the company. Accordingly, the cash payment from the employerto the employee is treated as compensation and taxed at ordinary income rates, and the employeris entitled to a tax deduction for this amount. The general rule that an employee is taxed oncompensation applies regardless of whether the compensation is in the form of a paycheck orequity. Many employees have the misconception that this equity award is a non-taxable gift.Unfortunately, the tax code does not allow an employer to make gifts to employees. The IRS callsthis compensation.Is there a way to structure this transaction for a different result? There are a few possible choicesthat defer the tax owed over multiple years, such as restricted stock and stock options, but everychoice has advantages and disadvantages. The following is an explanation of a few alternatives:OptionsThere are many rules surrounding the issuance of stock options that are outside the scope of thisarticle, but many companies issue options that meet certain requirements called incentive stockoptions (or “ISOs”). Assume that the company issues 1,000 incentive stock options 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 alternative is thatAlex has to pay $1,000 to exercise his option.Restricted StockThe company could issue shares to Alex subject to a vesting schedule over 3 years with 1/3rd ofthe shares vesting 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 potential 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
  2. 2. income rates on the full value, including the appreciation.Cash instead of StockA simple solution would be for the company to pay the equivalent value of the shares in cashcompensation to Alex. Alex would still 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 granting equitycompensation (i.e., with cash compensation the company must use cash to pay Alex and Alex hasno ownership to incentivize him to perform and remain employed with the company).Profits Interest (If an LLC)When a company is an LLC instead of a corporation it may grant what is called a profits interest. Aprofits 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 profits interest is not taxable upon grant. Theowner of a profits interest is taxed when and if the company allocates income to the member inthe future.Bottom Line: An employee or potential employee should understand the tax consequences ofreceiving equity compensation before agreeing to a particular arrangement. Otherwise, theemployee may get more than he or she bargained for when it comes time to pay taxes.