Like everyone, corporate executives want to minimize taxes on their compensation. Therefore, one of an employer’s goals when structuring executive pay is to minimize the tax burden on their most senior officers.
But a dilemma persists for achieving this objective. Most top executives pay substantial taxes at ordinary income tax rates, which currently range from 32% to 39%. That’s true even for most equity-based compensation, including non-qualified stock options, phantom stock, and restricted stock.
However, companies should consider structuring equity compensation so that it’s taxed at capital gains rates, which range from only 15% to 20% (not including certain employment taxes). In fact, while this approach does not appear to be much practiced, we think it could become a new standard for equity award grants.
Many businesses are structured as limited liability companies (LLCs) or partnerships. Generally, capital interests, profits interests, and phantom interests are granted by LLCs and partnerships, while stock options, stock appreciation rights, and phantom and restricted stock are granted by corporations.
A profits interest is an interest in a partnership or an LLC that allows the holder to participate in the entity’s value growth without incurring tax upon the receipt or vesting of the interest. Upon a sale of the partnership or LLC, the executive is entitled to participate (and is taxed on) the appreciation in value of the business measured from the date of grant to the date of sale.
Note that a profits interest is a unique tax vehicle that is the gold standard for executive compensation. On the date of grant, the liquidation value of the profits interest is $0. Therefore, if the LLC or partnership were liquidated on the day the profits interest was granted, the executive would receive no proceeds and owe no taxes.
In addition, if the profits interest is subject to vesting, there is no taxation at vesting. The executive will be taxed solely on his/her share of the future appreciation in the LLC’s or partnership’s value at capital gains rates, as opposed to ordinary income tax rates.
Generally, profits interests may be designed to provide for a fixed percentage of any gains or profits above the value of the LLC or partnership at the time the interest is granted or a fixed percentage over a specified threshold.
For example, the partnership or LLC may determine that the executive should receive a fixed percentage of all profits. In such case, if the entity is worth $5 million, an executive may be granted a profits interest equal to 10% of all gains and profits exceeding the $5 million.
Or, the partnership or LLC may determine that the existing investors should receive a guaranteed gain before the executive shares in the LLC’s or partnership’s profits.
In that case, the executive may, for example, be entitled to 10% of all gains and profits after existing partners or members have received back the amount of their initial investment plus a particular preferred return.
There are many design alternatives for the structure of a profits interest, all based on business considerations. Many profits interest grants provide for annual profit allocations and a liquidation value distributable upon certain terminations of the executive’s employment, a change in control, or other liquidation event.
In addition, the LLC or partnership may create customized distribution waterfalls where distributions occur if certain performance or other thresholds are met.
What About Corporations?
Savvy executives who were previously employed by LLCs or partnerships and become employed by a corporation are likely to be familiar with profits interests. If they are, they may well wish to replicate the economics of profits interests and receive equity-based incentives taxable at capital gains rates.
As a result, some corporations have become aware of the possibility of altering the design of traditional equity awards, in such a way that the economics are more akin to profits interest than plain vanilla equity awards.
Corporations can’t grant a profits interest, because their capital structure isn’t designed to accommodate it. However, with careful analysis and a little creativity, they can make awards that achieve practically the same tax advantages that profits interest enjoys.
Many corporations decide to grant restricted stock, or shares of common stock subject to certain vesting conditions that may be time-based, performance-based, or both.
Vested restricted stock is taxed at grant. However, unvested restricted stock is taxed at grant only if the executive elects to be taxed at grant by making an IRC Section 83(b) election. If such an election is made, the executive is taxed at grant on the excess of the value of the stock over the amount (if any) paid for such stock, at ordinary income tax rates, and any future appreciation is then taxed at capital gains tax rates.
If a corporation desires to grant restricted stock to allow an executive to make a Section 83(b) election, it may be necessary to create a new class of stock to avoid a large tax hit on the executive at the time of grant.
First, the new class of stock should include certain economic rights that replicate the distribution preferences, thresholds, and hurdles that are included in a profits interest, if it is desired that the restricted stock be paid upon the same payment terms as a profits interest.
Thus, the value the executive would receive would not simply be the value of a share of stock. It would be the amount of profits or other specific value that the corporation would like the executive to receive if the corporation were an LLC or partnership.
In addition, including distribution preferences, thresholds, and hurdles has the impact of lowering the fair market value of the new class of stock, as described below.
It’s also important that the new class of stock be classified as stock and not debt. A Section 83(b) election cannot be made with respect to debt. There’s a risk that if the new class of stock includes debt features, it may be classified as debt. Debt features include fixed cash interest, no voting rights, and certain enforcement rights.
The distribution preferences (including the new class of stock’s relationship to other classes of common stock and any preferred stock issued by the corporation that are outstanding), thresholds, and hurdles should be carefully drafted in the corporation’s certificate of incorporation, the equity plan document, and any equity award agreement to address these issues.
Further, the new class of stock should have a minimal value at grant. The most important objective of granting restricted stock that is substantially similar to profits interest is to have little or no tax as a result of the executive making the Section 83(b) election.
The corporation should obtain a valuation of the new class of stock prior to granting the restricted stock. The valuation should take into consideration the distribution preferences, thresholds, and hurdles that are incorporated into the new class of stock.
It also requires a comprehensive review of all outstanding classes of equity of the corporation, certain discounts and other key economic inputs, and an allocation framework that’s consistent with the economics of an LLC or a partnership.
This process is very technical and if the board of directors does not have the necessary expertise, a third-party valuation firm should be engaged to perform the valuation.
The executive’s holding period would begin at grant and the executive would achieve long-term capital gains tax treatment once the restricted stock is held for at least one year.
This approach to structuring equity-related compensation is likely to become more commonplace as executives search to maximize their compensation and retain as much of it as possible.
