Equity Based Compensation – Influencing the Choice of Entity
One of the most important decisions you make when starting a business is entity selection. Many factors affect the choice of entity, from legal, to tax, to initial cost, complexity, and exit alternatives. While I am a big proponent of the lean startup, there are two moments in your business timeline where going lean will actually cost you more in the long run – forming and exiting your business. It is important to have a knowledgeable CPA and lawyer working together to maximize the legal and tax implications of your selection.
Among to the most common choices of entities include Limited Liability Companies (LLC’s) and Corporations. Both of these entities offer great legal protection and limit liability to their owners but from a taxation standpoint are fundamentally different. Since offering equity as a form of compensation has become all the norm in the start-up world, this article will explore the differences between these two type of entities and the tax implications of incentivizing employees with a share of your company.
Limited Liabilities Companies
Since LLC’s came into existence in the late 1970’s they have added quite a bit of complexity to the U.S. Internal Revenue Code. Since LLC’s are formed under state law and LLC statues vary by state, the Internal Revenue Service (IRS) has taken the position that LLC’s are “flow-through” entities by default. This means any LLC with two or more members automatically becomes a partnership for federal tax purposes, unless an election is made to treat it otherwise.
Flow through entities typically don’t pay any federal entity level tax. Instead, the members, or owners, of a flow-through entity report their share of the LLC’s income on their individual tax returns, paying tax at their personal marginal income tax rates. The LLC reports income to each member on Schedule K-1. This income is allocated based on the LLC’s operating agreement. Selecting an LLC can limit your choices on equity based compensation, but LLC’s still remain a popular choice for service based businesses. The most common types of equity based compensation are “capital interests” and “profits interest”. Capital interests in a LLC can be viewed similar to issuance of stock in a corporation, while a profit interest offers the opportunity to share in future profits of a business.
Grant of a Capital Interest in an LLC
Compensating an employee of your company with a capital interest allows the company to write-off the grant as a deduction similar to that of W-2 wages. This taxable event doesn’t occur until the interest is fully vested, at which point, the employee recognizes ordinary income equal to the Fair Market Value (FMV) on the vest date1. The amount of the deduction received by the LLC is equal to the amount of ordinary income the employee recognizes as a result of the equity award. If the LLC was liquated today, the members would receive a portion of the LLC assets based on their capital ownership.
Grant of a Profits Interest in an LLC
Granting an employee an interest in profits of your LLC is a more flexible incentive that allows the individual to share in the future success of the company. Unlike the transfer of a capital interest, generally there is no deduction allowed by the LLC for the transfer of a profits interest. This also means that no income is recognized by the employee receiving the grant as a result of the transfer. The employee receiving the grant will however be taxed on future profits of the company. An important distinction between a profits interest and a capital interest is this – if the company were to liquidate the same day the grant becomes fully vested, a profits sharing individual would not be entitled to any of the assets of the LLC, while an individual with a capital interest would be entitled to a proportionate share of the LLCs assets (or capital).
Corporations are widely known in the start-up world as being the entity preferred by VC’s – mostly because of their ability to raise large amounts of capital, their flexibility from an equity standpoint, and as an added bonus, the investors don’t have any Schedule K-1s to wait on. While corporations do have their downfall – notoriously, double taxation, a tax at the entity level, and again at the individual level when profits are distributed to shareholders – they still are the preferred choice for businesses that plan to scale and want to offer compensation in the form of equity to their employees. There are quite a few ways to incentivize employees and offer the opportunity to participate in the financial success of your corporation through equity.
Below are the most popular types of equity compensation and a brief overview of the tax implications for individuals and the corporations.
Stock options – this includes Incentive Stock Options (ISOs) and non-qualified stock options (NQSOs). Stock options offer an employee or in the case of NQSOs, any person providing services to the corporation, the opportunity to purchase stock in the corporation at a future date for a price less than the current fair market value (FMV).
Incentive Stock Options are typically more favorable to employees, as a grant of ISO’s does not trigger a taxable event. When the options are exercised however, the difference between the FMV and the exercise price (“bargain element” or “spread price”) is an adjustment to the individual’s Alternative Minimum Tax (AMT) calculation. Corporation’s typically don’t net a deduction for offering this type of incentive, although there are exceptions.
Non-qualified Stock Options (NQSO) are similar to ISO’s, as there is no tax deduction for the corporation at the date of grant. With a NQSO, the taxable event occurs at the date of exercise, where the spread price is reported as ordinary income subject to FICA taxes. The corporation is entitled to a deduction for the amount of ordinary income recognized by the recipient.
Restricted Stock – Restricted Stock Units, or “RSUs” as they are commonly referred to as, are another common type of stock compensation utilized by corporation to incentive employees. Typically, RSUs are offered with a vesting period of 4-5 years, with the unvested portion forfeited if the employee resigns or is terminated. At the grant date, an employee can elect to pay tax on the current spread, or defer taxation until the RSUs are vested. The corporation is entitled to a tax deduction for RSUs issued and vested by an employee. In the eyes of the IRS, RSUs are viewed very similar to wages, as the corporation is required to pay FICA taxes, withhold federal taxes, and report the FMV of the vested portion in the employee’s W-2.
As always, every taxpayer’s situation is unique. If you have any questions about what entity would be the best solution for you, feel free to contact Paul Glantz, CPA at email@example.com
1 Since a grant of a capital interest in a LLC falls under the rules of IRC 83, an exception exists for the characterization and treatment of this transaction.