I recently had a company contact me about incentivizing its key employees to participate in the future growth of the company. The company’s CEO informed me that he recently had a consultant advise him that the only way to allow employees to participate in the future growth of a privately held company was through an Employee Stock Ownership Plan (also known as an “ESOP”). Contrary to the advice given to my client, while ESOPs can be used to allow key employees to participate in the future growth of a privately held company, ESOPs are not the only way to accomplish that goal.
Our firm often advises privately held companies on ways to incentivize its key employees, independent contractors or other key relationships (referred to herein as “key relationships”). A company will often want to provide its key relationships with a way to participate in the future growth of the company to increase the likelihood that the individual will remain in his or her role with the company and incentivize the individual to help grow the company’s value (to have some “skin in the game”).
There are numerous ways that a privately held company can establish a plan that allows its key relationships to participate in the company’s future growth. As mentioned before, ESOPs can be used to accomplish this objective, but often the funding costs and complex record keeping needed for ESOPs are too burdensome for small companies.
Below is a very brief and high-level summary of several arrangements that privately held companies can use in order to incentivize their key relationships. Please note that how the company is structured (for example a limited liability company or a corporation) and how a company is taxed (such as an S corporation, a partnership or a C corporation) can have an impact on which plan is right for the company.
Stock options in general provide the recipient the right to acquire a specified number of shares or membership interests in an entity over a specific period of time and for a specific price. There are primarily two (2) types of option plans: (i) a non-qualified option plan; and (ii) an incentive stock option plan (also known as a statutory option plan).
Non-Qualified Option Plan
A non-qualified plan offers some advantages over the incentive stock option plan in terms of simplicity, but can be less favorable to the recipient for certain tax purposes. Additionally, ownership interests under a non-qualified plan can be granted to participants other than employees.
Generally, options under a non-qualified plan are not taxable upon the time of grant unless the options have a readily ascertainable fair market value. Upon exercise of the options under a non-qualified plan, the recipient is taxed at ordinary income rates on the difference between the exercise price of the option and the fair market value of the ownership interests received upon the exercise of the option. In the event the ownership interests under the non-qualified plan are not vested at the time of exercise, the recipient can file an 83(b) election with the IRS to potentially provide the recipient with a more favorable tax treatment over time.
Incentive Stock Option Plan (or Statutory Option Plan)
Options under an incentive stock option plan can only be offered to employees and not to independent contractors or other parties. The primary benefit of an incentive stock option plan is that the employee recognizes no income either at the time of the grant of the option or at the time of the exercise of the option. The employee will recognize gain or loss under an incentive stock option plan when the ownership interests acquired through the option are sold.
One of the main drawbacks of an incentive stock option plan are the numerous statutory requirements that must be met in order for the plan to qualify as an incentive stock option plan and thus provide the recipient with favorable tax treatment. Among these restrictions are (please note this is not an exclusive list of these statutory restrictions):
The exercise price must not be less than 100% of the fair market value of the ownership interests on the date the option is granted (for owners of 10% or more of the company, the exercise price must equal at least 110% of the fair market value);
The recipient must be an employee of the company;
The plan cannot have a duration that exceeds 10 years;
The plan must be approved by the stockholders 12 months before or after the plan has been adopted;
The plan must designate the maximum number of ownership interests under the plan; and
Only $100,000 of the fair market value of the ownership interests exercisable by the recipient for the first time during any calendar year will be treated as incentive stock options.
Under a phantom stock plan, participants are awarded non-equity interest that represents a contractual right to receive a cash payment equal to a portion of the company’s value upon certain defined events. Typical defined payment events include termination of employment or a liquidity event (i.e., a sale or merger of the company).
The purpose of a phantom stock plan is to provide the participant with an “ownership like” award. The participant’s value in the phantom stock grows as the value of the company grows. The participant is taxed when the participant receives payments with respect to the phantom stock and the entire amount received is taxed as ordinary income.
Under restricted stock plans, a company actually transfers ownership interests in exchange for services, but the ownership interests are subject to certain restrictions. Under a restricted stock plan, the recipient is treated as an owner of the company at the time of the grant.
The recipient is not taxed on the restricted ownership interests until the restrictions lapse. After the restrictions lapse, the recipient is taxed at ordinary income rates on the difference between the fair market value of the stock and the price the recipient paid for the stock. Like option plans, however, the recipient may be able to file an 83(b) election with the IRS to limit its tax impact.
A “profits interest” is a special class of equity available to partnerships (or limited liability companies taxed as partnerships). A Profits interest is generally issued in exchange for services and only allows the recipient to participate in the future growth of the company. Essentially, the value of a profits interest at the grant date is $0.00 (and the participant receives $0.00 income on the grant date). The recipient of a profits interest is not taxed either at the grant date or at a vesting date. The recipient can receive favorable tax treatment on the profits interest going forward assuming certain guidelines established by the IRS are met.
One drawback of the profits interest is the valuation and accounting complexities associated with this method. Since the participant cannot be entitled to any share of the value of the business before the date the profits interests are issued, the Company must determine the value of the business on each issuance date and must keep an accounting of that value for the benefit of the existing members.
If your company is considering establishing a plan to incentivize its key employees or other relationships that would allow such parties to participate in the future growth and potential ownership of the company, please be sure to consult with your legal and tax advisor on the various plans available to your company. As mentioned above, there are numerous options available and each option has different ownership and tax considerations to consider.
 Pease note, there are certain holding periods that affect the tax impact of the options under an incentive stock option plan and the recipient may also be subject to alternative minimum tax.