The tax implications of compensating executives with alternative ownership

For executive employees looking to either join a company or stay with one, an important differentiator is compensation. A generous salary and benefits package will no longer suffice.

Executive employees are looking beyond the company car, adoption assistance, and retirement plan funding to a potentially more advantageous perk: a stake in the business through direct ownership or economic incidents of ownership.

Prior to offering ownership compensation, businesses should consider the tax consequences. The IRS reviews executive compensation arrangements in routine exams and focuses on the matching of income and deduction between the employee and employer. For most compensation arrangements, specific requirements must be met to ensure the most efficient tax consequences to both the employer and the employee. Discussed below are a few of the compensation options available as well as their potential tax implications.

First, however, a business should determine whether executive employees should have actual ownership versus an ownership-like vehicle. Key considerations include:

  • What does the executive employee bring to the table? Is this a person that could be easily replaced or someone who is instrumental in the overall success to the organization?
  • Is the executive employee someone who may eventually buy the entire company?
  • How does the executive employee fit into the company’s succession plan?
  • Is the executive employee viewed as a business partner?
  • Do you want the employee to have all the legal rights of ownership? Are you comfortable, as the business owner, with the changes to your rights and obligations to the company and the executive?

There are several different compensation mechanisms related to ownership and ownership-like vehicles, including stock options, profits-only partnership interests, stock appreciation rights (SARs), and phantom stock plans.

Stock options

Compensating executive employees using stock options allows the employees to share in the growth of the company by providing an avenue to actual ownership. Stock options may be used by corporations (both C and S corporations), partnerships, and limited liability company (LLC) interests. The date the company provides the executive employee with a contractual right to purchase the stock at a specified price is known as the grant date. Stock options may have a period of time before the executive employee may exercise this right, known as a vesting period. Once the right is exercised, the executive would pay the company for the shares. Executives sometimes exercise and hold the stock, and other times, they opt to exercise and immediately sell the stock. Finally, if an executive does not exercise the options in the allotted time frame, the option is said to lapse.

The tax consequences to the company and the executive will be determined based on whether the option qualifies as an incentive stock option (ISO). If the option does not qualify as an ISO, the option is a nonqualified stock option (NQSO). To be an ISO, the stock option must meet several specific statutory requirements, including that the ISO grantee is an employee (and not a director or independent contractor) and the exercise price being equal to or greater than the fair-market value of the stock on the date of grant.

If the stock option is an ISO, the company does not receive a deduction and the employee does not receive income on the grant date or the exercise date (except as an alternative minimum tax item). When executives dispose of the ISO, they receive capital gain treatment assuming they meet the statutory requirements. The company would not receive a deduction for the stock option nor would the executive be subject to federal income tax withholding (FITW), Federal Insurance Contributions Act (FICA) tax, or Federal Unemployment Tax Act (FUTA) tax. If the stock options lapse, there is no income tax impact to either the company or the employee.

If the stock option is an NQSO, the company receives a deduction to the extent the exercise price is less than the fair market value; the executive is compensated to the same extent and subject to FITW, FICA, and FUTA. Also, when executives dispose of the stock, they receive ordinary tax treatment rather than capital gain treatment, assuming that the executive exercises the option and then immediately sells the option. Typically, most NQSOs are exercised and sold at a liquidity event, such as an acquisition of the company. Most executives prefer to receive ISOs whereas most businesses prefer NQSOs. Like an ISO option, if the NQSO lapses, there is no income tax impact to either the company or the employee.

Profits-only partnership interests

Another equity-like compensation arrangement is a profits-only partnership interest. A profits-only partnership interest allows an executive to share in the upside of business, while not creating any current taxation, if structured properly. This technique may be used in a partnership, limited partnership (LP), a limited liability partnership (LLP), and LLC contexts. Depending on the partnership agreement or operating agreement, the profits-only partnership interest may have a right to participate in the management and overall strategic direction of the entity.

For example, assume AB partnership has two equal partners, A and B, who want to provide C with a 10 percent profits-only interest. If the AB partnership has $100 of income, the income would be divided $45, $45, and $10, to A, B, and C, respectively. If the AB partnership has a loss of $100, the loss would be divided $50, $50, and $0, to A, B, and C, respectively. C has a strong incentive to make sure the partnership generates income in any given year and would only share in the upside of the business.

The granting of a profits-only partnership interest is tax-free if it is structured properly. In order to be tax-free to the executive, the interest must meet the following criteria:

  1. the partnership does not have a predictable income stream from a lease or debt security;
  2. the interest is not disposed within two years; and
  3. the interest is not a limited partner interest in a publicly traded partnership.

The company would not receive a deduction for the grant of the partnership interest if it is tax-free to the profits-only interest partner. If any of the above factors are not present, the fair market value of the interest at the time of the grant would be taxable to the executive and would be a deduction for the business.

Stock appreciation rights/phantom stock plans

Stock appreciation rights (SARs) and phantom stock plans provide businesses a way to let their key executives share in the growth of the company, while allowing the owners to maintain undiluted ownership. Like stock options, both SARs and phantom stock plans allow the company to place a vesting period.

SARs allow an executive to share in the growth in the stock price for a certain number of shares. The company would pay the executive when he or she exercises the right under the plan. The payment would be the difference between the current stock value less the stock value time at grant.

Like SARs, a phantom stock plan provides the executive with a certain number of shares without any actual transference of ownership. Unlike a SARs plan, a phantom stock plan is for a specified time frame. The executive would receive a credit for any dividends that are paid on the outstanding shares of stock, and when the time frame expires, the executive would be credited with growth in the company’s stock value.

Under both SARs and phantom stock plans, executives have ordinary income tax consequences when they receive cash from the plan. Upon the payment, the company would receive a deduction under the matching principle. The main difference between SARs and phantom stock plans relates to FICA and FUTA tax purposes. For SARs, the FICA and FUTA taxes are paid when the executive receives cash. For a phantom stock plan, FICA and FUTA payments are paid when the services are performed or the employee is vested in the plan.

Before implementing the compensation arrangements described in this article, it is recommended that you consult your Baker Tilly tax advisor to make certain that the tax consequences to your company and the executive employees are understood.