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Financial
Jan 2, 2017

How To Incentivize Employees With Equity Ownership

Sponsored Content provided by Adam Shay - Director of VCFO Services, Red Bike Advisors

As we've seen more scalable startups in the Wilmington area, we've received an increase in inquiries as to how to incentivize employees with equity ownership. 

There are a couple of different ways this can be accomplished, and each approach has different tax treatments.

We'll cover some of the tools available, but the devil is in the details so we really recommend working closely with an experienced attorney that is collaborating with your CPA firm as part of this process. 

With a lot of these, equity incentive approaches require a 409A valuation to take place, which can mean an additional cost of putting them in place.

If you are starting a company from scratch and you think there is a possibility you are going to offer equity to future employees or bring in external investors, we recommend you set up a corporation and not an LLC. The reason for this is a corporation can bring in additional owners by issuing additional shares. This will avoid triggering adverse tax consequences for the existing owners that would occur under an LLC structure.

There are a couple of different ways to offer equity-type ownership to employees. I've listed them in the order in which we most commonly see them.

Stock Options

With stock options, there typically is no tax for the recipient when granted, but there is at a later time (when and what type depends upon the option type). The employer typically does not get a tax deduction with stock options. Converting options to shares is referred to as the exercise of the options. The exercise occurs at a price- the money that must be paid for the shares of stock.  There are two types of stock options - nonqualified stock options (NQSOs) and incentive stock options (ISOs). 
  • Incentive Stock Options (ISOs) - These are often referred to as qualified stock options since they qualify to receive favorable tax treatment.     There is no tax at the exercise of these options. If you sell the stock purchased via the options at least two years from the date the option was granted and as well as hold the actual stock for at least one year, then the difference between the stock sale price and the option exercise price is treated as favorable long-term capital gains.
  • Nonqualified Stock Options (NSQOs) - There are no favorable tax treatments for NSQOs.  There is no tax upon the grant of the options, but the difference between the grant and exercise price is taxed as ordinary income.

Restricted Stock

This is typically the issuance of shares to an employee which does not occur until some sort of restriction is listed, whether that is length of service restriction or company or individual goals restrictions. 
 
As far as taxation, the employee typically has a choice to make at the grant time. The employee can choose to make an 83b election within 30 days of the restricted stock grant and recognize the stock as ordinary income at the time it is granted. With a growing startup, this typically results in a lesser tax hit for the employee as the stock's value will continue to grow. The risk is that the employee could have taxable income on stock that is worthless down the road. 
 
The other option is for the employee to wait for the restriction to be lifted, at which point the stock received gets recognized as ordinary income at that time.  The employer gets a tax deduction on any amount the employee pays taxes on.
 

Phantom Equity

Phantom equity can allow employees to receive some of the benefits of an exit without owning actual shares of the company. This approach is typically covered in an employment contract.

For example, if Bob works with the company for three years and is still with the company when an exit event happens, he would receive income equal to 5 percent of the company's sales price. This would be ordinary income to Bob and would be a tax deduction for the business.
 

Other Flavors Available

Employees can receive stock as compensation without restrictions or have the ability to purchase shares within a company.
 
My goal today was to give you an overview of some of the equity compensation tools available to scaling and growing companies.  There are a lot of considerations to factor in, so again we strongly recommend that you work with a professional when considering your options, no pun intended.

Adam Shay, CPA (N.C. License Number 35961), MBA, is managing partner of Adam Shay CPA, PLLC. He focuses on minimizing taxes and improving the financial results of entrepreneurs, and is actively involved in supporting the Wilmington entrepreneurial and startup community. For more information, visit http://www.wilmingtontaxesandaccounting.com/ or email him at [email protected]. He can also be reached by phone at (910) 256-3456.

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