Andrew Gilbert is a partner at Croke Fairchild Morgan & Beres
Any opinions, analyses, and conclusions or recommendations expressed in this article are those of the author alone and do not reflect the views of their employer or eShares, Inc. DBA Carta, Inc.
What should a company do if it wants to issue equity to current employees without the employees incurring tax on the date of grant—and continue to provide an employer-paid portion of benefits and treat the grantees as employees for tax purposes?
In the LLC context, there are two common approaches to addressing this issue: create a separate entity, or issue unit appreciation rights. Each of these options have pros and cons from the employee’s perspective and the employer’s perspective.
The considerations outlined below are some of the primary considerations that our clients consider; however, there are other considerations which should be discussed with counsel depending on your specific facts and circumstances.
Partnerships and tax law
Under current tax law, when a W-2 employee of an LLC is issued equity in their employer, that employee becomes a “partner” for tax purposes (assuming that the LLC is taxed as a partnership and not a corporation). The grantee must be “treated as a partner for all purposes” once they receive that equity, meaning that they will lose certain benefits previously provided by the company when they were an employee. These include employer contributions to certain medical and welfare benefits, eligibility for certain retirement and welfare benefits, and the employer payment of a portion of FICA taxes (i.e., Social Security and Medicare under the Federal Insurance Contribution Act).
Often, these negative consequences (from the employee’s perspective) can put a negative spin on an otherwise positive move by the company. Fortunately there is a way to get the best of both worlds.
This article assumes that the company does not want to impose a taxable event on the employee at the time of grant and therefore will be issuing equity which grants to the employee a share of only future value in the company (and that the company does not want to require the employee to pay anything to the company for the equity on the date of grant).
If the company wanted the employee to participate in the existing value of the company (or wants the employee to purchase the equity at fair market value), there are other options available and should be discussed with legal counsel.
We note that the facts and circumstances of each situation are different, and you should confer with legal counsel and your accountants to figure out the best solution for your situation. Also, there are significant tax, compliance, accounting and regulatory considerations when you are giving equity to employees (in particular if any of the employees are non-U.S. persons for U.S. tax purposes). Those considerations are beyond the scope of this article and should be discussed with legal, accounting, and tax advisors prior to adopting any incentive plans or making any equity grants.
Option A: Creation of an “EmployCo” to hold profits interests
The vast majority of our LLC clients end up issuing “profits interests” to employees as part of their equity incentive plan. Here are a few high-level features that are relevant to understanding this type of equity:
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Each profits interest should be issued taking into account the fair market value of the LLC on the date of grant (as determined by the board of the company, usually based on either a 409A valuation or the price per unit used in the most recently completed equity financing). The fair market value of the LLC determines the distribution “hurdle” above which the profits interest grantee begins to participate in distributions. This mechanism ensures that the “liquidation value” of the profits interest is zero on the date of grant.
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Generally, employees can file an 83(b) election to include the value of the profits interest (i.e., $0 under the “liquidation value” appraisal method) in their tax return for the current tax year, and later enjoy more favorable capital gains treatment upon a change-of-control transaction.
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Profits interests are actual equity interests for tax purposes. They are partnership interests that give the owner the right to receive a percentage of the increase in value of the partnership at a future date (but no interest in the existing capital of the company at the time of grant). Normally, for companies which are not focused on distributing cash out of the company, profits interests do not participate in any dividend distributions. Rather profits interests recognize their value/payout upon a change-of-control transaction.
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Employees should be treated as partners on a going-forward basis since the employees are being issued equity interests.
It is the last bullet above which drives certain planning to be undertaken. In many cases, companies want to continue treating an individual as an “employee” for tax and benefits purposes.
To achieve this result, many companies create a separate entity (a new LLC)—let’s call this hypothetical entity “EmployCo”—and then issue a profits interest to the employee directly, who in turn contributes those profits interest into the EmployCo in exchange for a profits interest (or “tracking unit” depending on the structure) of the EmployCo.
The units issued by the EmployCo are then subject to the same parameters as if the profits interests were issued directly by the company to the employee (i.e., the company can set the vesting schedule/parameters, forfeiture provisions, etc.), because the units issued by the EmployCo to the employees mirror the units issued by the company to the EmployCo.
Under this arrangement, an employee can typically maintain their status as an employee of the company while, at the same time, holding equity in EmployCo (which is economically tied to the profits interests of the company). It should be noted that the IRS has invited comments on the tax consequences of structures that rely on an EmployCo, the viability of which may be limited once the IRS issues further guidance.
From the employee’s perspective, this is the preferred option since there is no change to their eligibility or costs for benefits, they have the possibility to share in the appreciation of the company if there is a change-of-control transaction, and such appreciation will benefit from the capital gains tax treatment (if an 83(b) election is made, as described below).
However, there is an additional administrative burden and cost to the company because it has to establish a new entity and prepare the corresponding annual filings. Generally, however, this additional burden and costs are outweighed by the employee’s benefit.
One item of particular note with respect to the tax treatment of profits interests for the employee is that an 83(b) Election must be made within 30 days of the initial grant in order for the appreciated amount to be eligible to be treated as a capital gain.
This is a very strict rule that the IRS enforces with few, if any, exceptions. If the company decides to issue profits interests, best practice is for an 83(b) Election Form to be attached to the equity grant to make sure that the employee understands the importance of making this election within the 30-day window following the date of grant.
Option B: Issuing unit appreciation rights
Some of our clients do not want the burden of creating a separate entity to issue profits interests, and they look for an alternative structure which will still allow them to keep their employees classified as “employees” while giving them some equity (or equity-like rights).
In these cases, the company might issue what are called unit appreciation rights (“UARs”). While UARs are functionally similar to “stock appreciation rights” in the corporation context, they are not as well known. Accordingly, there is limited case law and tax guidance as compared to that of the more commonly understood profits interest.
Here are a few high-level features that are relevant to understanding UARs:
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UARs give the employee the right to receive the appreciated value of the company’s units at a future date.
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UARs do not award an actual partnership interest in the company, rather they are based on the increased value of the company at some certain future date. UARs are more akin to a contractual right and are often viewed as such by employees (leaving them to feel as though they do not have “real” equity).
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UARs are based on equity values (they are not actual equity). Accordingly, distributions upon a change-of-control transaction are taxed at ordinary income tax rates instead of capital gain rates. This can be a major downside for the employee as compared to a profits interest.
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UARs do not rise to the level of an actual partnership interest so the company can continue to treat the employee as an “employee” (rather than as a partner) for purposes of subsidizing benefits, paying W-2 wages and the employer portion of FICA.
Unlike Option A, Option B allows the company to achieve similar results without the additional burden of setting up an “EmployCo.”
There are other practical considerations, however, with respect to UARs that companies should consider; including:
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how the employee will view this incentive compensation (i.e., some employees see this as “not real equity”)
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what the actual tax burden on the employee may be (i.e., UARs can result in a higher tax burden on the employee)
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how to manage the uncertainty due to the fact that there is limited to no regulatory guidance for UARs (i.e., how the Internal Revenue Service or a court will view UARs is not as certain as a profits interest), and
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UARs are generally drafted like options and only valid for a period of 10 years (i.e., absent a change-of-control transaction, the UARs become worthless unless the company reissues them at the time of expiration).
From the company’s perspective, UARs may be an easier option with a lower administrative burden; however, there are material downsides for the employee when compared to a profits interest. And often companies find that the employee’s downside still favors a profits interest over the administratively simpler UAR.
How it works and why this equity structure might work best
There are many similarities between profits interests and UARs. Both are designed to align an employee’s economic interest with that of the company and both can be structured only to pay out upon a triggering event (i.e., they can be drafted to not participate in periodic distributions of capital, if any).
Further, neither requires an initial cash outlay by the recipient, results in a taxable event to the recipient prior to receiving a distribution (as long as the initial grant is made at fair market value), or provides for voting rights.
The main differences are as follows:
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Profits interests award an actual equity interest in the partnership, while UARs do not. Because there is no actual equity interest owned through UARs, employees perceive UARs to provide them “less” of an ownership stake. Employees often see this as a more complicated bonus arrangement.
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Profits interests require the creation of a separate entity to structure the award of the interests to avoid reclassifying employees as partners. UARs do not require an additional entity.
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Profits interests provide for capital gain treatment of distributions upon triggering events, which if held for more than a year will be lower than ordinary income tax rates that would otherwise apply. Distributions based on UARs are taxed as ordinary income, without the possibility of a lower long-term capital gain rate. This difference is often the primary reason why employees prefer profits interests.
Additional considerations
From a practical perspective, profits interests are generally more common and employees have a better understanding of what they are getting. UARs, on the other hand, are less common and can leave employees wondering what they actually received in their grants versus what they would get in a regular transaction bonus triggered by a sale of the company.
Additionally, profits interests are issued at the date of grant (subject to vesting) and do not need to be amended or changed regardless of how long they exist prior to a change of control transaction. UARs, on the other hand, are generally only valid for 10 years, meaning there can be additional time pressure on the company and employee relationship if there has not been a change-of-control transaction within that 10-year timeframe.
As noted above, while there is generally more guidance regarding profits interests, the IRS has invited comments on the tax consequences of structures that rely on an EmployCo, the viability of which may be limited once the IRS issues further guidance; therefore, it is critically important to consult with legal and tax counsel before issuing any equity.
From a legal perspective, it is important to reiterate that there exists more case law and related tax guidance with respect to profits interests while the same cannot be said for UARs. Accordingly, anyone considering UARs should obtain legal counsel, especially if their company is located in an employee-favorable jurisdiction such as California.
The company should also consider that upon the issuance of equity to the employees, there may be other implications to the company in terms of having to provide information to the equity recipients about the performance of the company, which includes making the books and records available. For the employee it can also further complicate their tax filings (e.g., requiring quarterly estimated income tax payments).
Finally, many clients want to understand the differences in vesting between the two options. The scope of vesting considerations is beyond the scope of this particular article, but legal counsel should be able to provide guidance through the many layers of aligning incentives in the structuring of the vesting schedule.
Also, as long as the drafting is done carefully (and any employment agreement provisions are reviewed in detail), the vesting of the two options can largely be structured the same (i.e., both profits interests and UARs can be subject to the same vesting, forfeiture, accelerated vesting, termination treatment for cause or the employee quitting for good reason, etc.).
Tax treatment for equity holders
Assuming they have been issued correctly and the IRS has not made an adverse ruling with respect to these structures, profits interest distributions upon triggering transactions are generally taxed as capital gains, and may benefit from the lower long-term capital gain treatment. Distributions based on UARs are taxed as ordinary income, and there is no possibility of lower long-term capital gains rates. This is often one of the main drivers of employees preferring profits interests.
As noted above an 83(b) Election must be made within 30 days of the initial grant in order for the appreciated amount to be eligible to be treated as a capital gain. This is a very strict rule that the IRS enforces with few, if any, exceptions.
Tax treatment for companies
Generally, upon a change-of-control transaction, profits interests are paid out like other equity holders; however, since the holders are generally current service providers to the company, the company will often still run any payment through their payroll provider and withhold any applicable amounts.
However, since UARs are not actual partnership interests, the entire amount paid to the employee will be considered income to that employee. Therefore, the company will want to run any such payments through their payroll provider and withhold at the employee’s standard withholding rates. This amount will be included on their W-2 for the year as compensation, and will generally be deductible as an expense by the company.
What valuations are needed for this equity type
Fair market valuations are needed as of the date of grant of either profits interests or UARs to avoid negative tax consequences to the employee. In the corporation/options context, this is often done on the basis of a 409A valuation or based upon the most recently completed equity financing of the company (depending on how long ago that financing was completed). The same principle is true in the LLC context, though sometimes accountants will say that the calculation is an “equity valuation” rather than a 409A valuation.
In either case, the company will need to work closely with its accountants to determine the fair market value at the date of grant such that the employee will only participate in the incremental increase in the value of the company above the value determined at the time of grant.
How employees can understand the value of this equity
Assuming that the company does not want the employee to be hit with a taxable event on the date of grant, the company is required to issue profits interests and UARs at the current fair market value on the date of grant. This means that if the company were to liquidate (or enter into a change-of-control transaction at the same value as the equity grant) on the date of grant, the employee would be paid zero dollars. Said another way, the employee only participates in the added upside value of the company (if any) from and after the date of grant.
While some employees may question why their grant does not have any immediate value and there is only value if the value of the company increases, it is an important tool for the company to ensure that the equity granted to the employee serves its purpose to align incentives for the employee to continue to create net value for the company going forward.
Our clients often find that explaining to employees that she or he is participating in the upside of value creation between the date of grant and a change-of-control transaction is generally well received once it is explained. Employees tend to understand the narrative that legacy employees who built the company before the date of the grant of new equity get to participate in the growth from their efforts, and the new employee grant is there for them to participate in the growth that they put in going forward.
This also gives the company an opportunity to create additional positive messaging in connection with future equity raises (assuming the subsequent equity raise is at a higher per unit price than the fair market value of the employee equity grant, and is not a “down round”), by sharing the higher per share value with the employees who can then calculate their unrealized gains based on the new per share valuation versus the fair market value issuance price.