Employee Equity Tax Implications

Are you considering giving an employee equity in your company? Employee equity is a tool that is often considered by business owners or requested by employees, but what are the tax implications associated with employee equity for you, your company, and the employee?

This article is the second in our series focusing on employee equity considerations and focuses on employee equity tax implications for closely-held private companies. Also, as the overwhelming majority of private companies today are “pass-through” entities for federal income tax purposes (disregarded entities, tax partnerships, and S-corporations), this article focuses on tax implications specific to pass-through entities.

Here are seven items for you to consider with respect to taxes before you make the decision to give an employee equity in your company:

1.     Taxable Income. The most important tax implication for you to be aware of is that, if you do no tax planning, the fair market value of employee equity gifted to an employee (as opposed to purchased by an employee) is compensation to the employee taxed at the employee’s ordinary income tax rate. While the impact of this will vary depending on the current fair market value of the company and the amount of equity being given, it is usually not preferable for the employee to be given a non-cash asset that they will be taxed on. For example purposes, if your company has a fair market value of $1,000,000 and you want to give your employee a 10% equity interest, the employee is receiving compensation of $100,000 and a potential tax liability of up to $37,000 (at current tax rates).

2.     Taxable Income Solutions. Potential solutions to the taxable income issue in a pass-through entity are as follows:

• The employee can purchase the equity for its fair market value and the purchase could be financed by the company.

• The company can bonus the employee up for the employee’s tax liability resulting from the gift of the equity.

• If the employee is a family member, you may be able to make a tax-free gift of your equity to such family member.

• A company that is taxed as a partnership (a limited partnership or limited liability company) can create a class of equity called “profits interests”.

• The employee can be issued “phantom equity” or “synthetic equity”.

• The company can implement a “non-qualified stock option” plan.

We will discuss these potential solutions in more detail in our next article in this series on employee equity. 

3.     K-1 = No W-2. In a company that is taxed as a tax partnership, holders of equity interests (including profits interests) are considered partners in the company for tax purposes and will receive a Form K-1 each year. Consequently, such individuals cannot be treated as an employee for federal employment tax purposes and also receive a W-2 from the company, and may also be ineligible to enroll in the Company’s benefit plans. Instead of W-2 wages, any wage payments made to such individuals are characterized as guaranteed payments for services, and such individuals must self-withhold FICA and make estimated tax payments on any income allocated to them by the LLC.

4.     S-Corp Issues. Individuals who own equity interests in a company taxed as an S-corporation can also be W-2 employees of the company. However, S-corporations do create other unique tax issues as it relates to employee equity. Primarily, the holders of equity interests in an S-corporation must be entitled to receive the same operating distributions and liquidating distributions from the S-corporation as all other holders of equity interests in an S-corporation (on a pro rata basis by ownership percentage). This means that certain solutions to the taxable income issue, such as profits interests, are not available in an S-corporation. This also means that, if an employee is gifted equity interests in an S-corporation, they get to participate in any distributions made starting day 1, which may be inequitable to you and any other owners of the company who have unreturned capital investments in the company.

5.     Vesting Issues. When employee equity is issued to an employee, it is common to utilize a structure whereby the equity will vest over time to protect the company and incentivize the employee to stick around. Due to the taxable income issue discussed above, if the employee is taxed on the value of the equity when it vests, the employee could have a greater tax liability if the value of the company has increased since the date the equity was granted. As a solution to this, the employee may make a Section 83(b) election with the IRS that will tax the value of the equity at the time it is granted, rather than at the time of vesting.

6.     Phantom Income. Pass-through entities often generate “phantom income”. This occurs when the company has a profit for tax purposes but doesn’t have cash available to distribute those profits to the owners of the company. This commonly occurs when the company is repaying debt (as principal payments are not deductible) or reinvesting profits to grow. If an employee will be allocated profits for tax purposes, but will not receive commensurate distributions, the company may need to budget to make tax distributions so that the employee and other owners at least receive cash to cover the tax liability from the profits allocated to them.

7.     Added Accounting and Tax Complexity. Employee equity may create more complex accounting and tax structures for you, your company and the employee. You will want to make sure you weigh the pros and cons of any such additional complexities and have an accountant who can help. It is also important that the employee recognizes the additional complexity to their tax structure (especially if they can no longer be a W-2 employee) and has an accountant who can help.

The items discussed above are not intended to be a comprehensive overview of all tax implications associated with employee equity, but we hope they alert you to some of the common issues that arise with employee equity in closely-held private companies with pass-through tax structures. We strongly recommend that you discuss issuing employee equity with your attorney and accountant before making any promises to employees.

Be on the lookout for the next article in our series focusing on employee equity considerations where we will discuss the potential solutions described above in more detail.