Companies often wish to compensate founders and employees with equity instead of cash for reasons such as: (i) the company is new and has a low (or no) cash flow and (ii) the company wants to incentivize performance by giving its founders and employees a stake in the company’s success.

On the other hand, founders and employees may wish to receive equity instead of cash because if the company is successful, the equity could become more valuable than what would have been given in cash. There are numerous types of equity, and the particular type of equity in each instance will be largely dictated by the company’s entity type.

The most common choices of entities are limited liability companies (LLCs) and corporations.

LLCs

LLCs can have various types of equity, the two most common for compensating founders and employees being Capital Interests and Profits Interests.

I. Membership Interests That Come With a Capital Account (“Capital Interests”)

Capital interests entitle the members of the LLC to distributions from the LLC under certain circumstances enumerated in the operating agreement. Capital interests can be given pursuant to a vesting (or reverse vesting) schedule. If interests are vested over time, then the holder’s interests are subject to risk of forfeiture until such interests vest. Capital interests can be restricted so that there are certain prohibitions on transfer.

If the interests are vested, they are taxed upon grant. If the interests are not vested, the member could make an 83(b) election and pay taxes on the valued amount at the time of grant or wait and pay taxes on the value of the interests at the time they vest.

Section 83(b) of the Internal Revenue Code allows for you to pay taxes on equity on the grant date rather than waiting for the equity to vest. “This revenue procedure applies to taxpayers who receive substantially nonvested property in connection with the performance of services” (IRS Rev. Proc. 2012-29). Elections pursuant to 83(b) must be made within 30 days of grant. Additionally, the company’s fair market value must be determined.

II. Profits Interests

Profits interests are governed by the IRS revenue rulings. Revenue Procedure 93-27 defines profits interest as “a partnership interest other than a capital interest.” Typically, “if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership” (Rev. Proc. 93-27)

Profits interests are granted for services rendered or to be rendered to the company. Profits interests grant the holder a share of future profits and losses. Profits interests do not give the holder any right to distributions if the company is sold immediately after grant. The LLC must prepare a profits interests plan and form of profits interest grant agreement.

Profits interests are not taxable, unless the “hurdle amount” was miscalculated. Capital gain/loss applies on sale of interest (except for hot assets) as required by IRC Section 751. “Hot assets” are “unrealized receivables” and “inventory items” as defined under IRC Section 751.

Corporations

Corporations’ basic form of ownership is stock. Stock can be granted in various ways:

I. Restricted Stock

Restricted stock is subject to a risk of forfeiture. Common triggers for the risk of forfeiture to end are:

The holder has been employed with the company for a certain amount of time
The holder and/or the company have reached certain predetermined milestones
Certain events can accelerate the amount of time the stock is subject to risk of forfeiture, such as:
Company change of control
Holder is terminated by the company without cause

Federal income tax and FICA tax apply when the risk of forfeiture lapses. Holders can make an 83(b) election at time of grant, which allows them to pay tax on the value of the stock at the date of grant instead of the value when the substantial risk of forfeiture lapses.

II. Stock Options

Stock options confer the right to purchase stock in the future at a price specified upon grant of the option. There are two types of stock options:

A) Non-qualified Stock Options

Non-qualified stock options are not taxed upon grant, but upon exercise of the option at the fair market value at ordinary income rates. The company gets a deduction. They are taxed upon sale as capital gain/loss (difference between the sale price and the fair market value at exercise). The holder can be owner or employee

B) Incentive Stock Options

Incentive stock options provide employees with more favorable tax treatment than nonqualified stock options because they are not subject to ordinary income taxes at the time of grant or upon exercise. If they are held for more than one year from the time of exercise and two years from the time of grant, they are eligible for long term capital gain.

The company is not entitled to a tax deduction on an employee’s exercise of an incentive stock option if the employee meets the holding requirements.

Some of these requirements are:

Holder must be an employee of the company
The company must have a formal option plan that has been approved by the shareholders
The plan must include the maximum aggregate number of shares that may be issued through the exercise of incentive stock options
The option must be granted within ten years of the date the plan was adopted or the date the plan was approved by the shareholders (whichever is earlier)
The exercise price of the option must not be less than (i) the fair market value of the underlying shares on the grant date for employees who are not 10% shareholders; or (ii) 110% of the fair market value of the underlying shares on the grant date for employees who are 10% shareholders
The options cannot be transferred by the employee, other than upon such employee’s death
The options are only exercisable during the holder’s life by such holder
For each employee, the aggregate fair market value of the options (determined by the exercise price) that become exercisable for the first time in any calendar year cannot exceed $100,000

Written by Lauren Roberts

This article was originally published on UpCounsel