Granting employees equity interests helps keep employees and key executives invested—both financially and emotionally—in the business, thereby incentivizing employees and encouraging employee retention.

For startups and small businesses that are low on cash, granting equity interests is also a way to compensate employees, recruit new talent, or give current employees a raise without dipping into the current year’s cash reserves.

Equity compensation is a broad category that includes profits interests, incentive stock options (ISOs), and non-qualified stock options (Non-Quals).

Corporations cannot grant profits interests but may grant ISOs and non-quals, while generally profits interests would be granted by businesses that are organized as partnerships.

As a result, businesses have many forms of compensation that they may choose from to pay employees or executives beyond their normal wages.

Whether you are working on an M&A deal as an investment banker, as a lawyer, or as the seller or the buyer of a business, it’s important to know what each of these terms mean. More importantly, each type of equity compensation has specific tax consequences for your business.

Profits Interests vs Options – Summary

  Profits Interests Incentive Stock Options (ISOs) Non-qualified Stock Options (Non-Quals)
Definition The employee receives a percentage of future profits. The employee does not have to contribute capital in order to receive profits interests. Subject to stringent tax rules in order to qualify for the preferential tax treatment.  For example, the exercise price of the ISO must be at least the fair market value of the stock on grant date, only employees are eligible to receive ISOs, and more. Stock options that do not qualify as ISOs.
Who is Involved? Partnerships and LLCs grant profits interests to employees. Any corporation, private or public, may grant ISOs. They are usually reserved for key executives and  employees. Similar to ISOs.
Tax Consequences If structured correctly, the employee is not taxed on the receipt of a profits interest, nor when it is vested.[1]  Increases in value upon the sale of the stock are usually taxed at capital gains rate (for year 2020, 0%, 15%, or 20% depending on the individual’s income). No tax on grant or exercise of ISOs.  If the employee holds the shares for two years after grant and one year after exercise, upon sale of the shares, the employee is taxed at the lower capital gains rate. However, if the option is sold before the aforementioned periods, the employee will be subject to tax at the ordinary income tax rate. No tax upon receipt of grant.  However, on the date of exercise, the individual will be taxed at ordinary income tax rates (ranging from 10% to 37% in 2020)[2] on the difference between the fair market value on that date and the strike price.

Takeaways

The ability to issue profits interests versus options is limited by the business structure in use.

Only partnerships or entities that are treated as partnerships for tax purposes (such as LLCs) may issue profits interest.  Partnerships may also issue options (but not ISOs) and sometimes they are preferable because options are easier for employees to understand.

Moreover, the grant of options as opposed to profits interests mean that the employees will not have to deal with the tax compliance complexities relating to partnerships.      

Corporations and Profits Interests

If a business is organized as a corporation, it will not be able to grant profits interests.  Instead it is limited to issuing options (or it may also consider granting stock appreciation rights).  At first glance, it may seem like a non-brainer to issue ISOs as opposed to Non-Quals because of the favorable tax treatment that may be available.

However, ISOs must meet a myriad of tax rules in order to qualify as such.  Further, from the corporation’s perspective, Non-quals may be considered more attractive because the corporation may be eligible for a compensation deduction equal to the amount the employee includes in income upon exercise.

Consequences of Mergers & Acquisitions in an Option Scenario

Remember when we said that ISOs have a required holding period, and that if it wasn’t satisfied, the employee would be taxed at the ordinary income tax rate instead of the lower capital gains rate?

One thing that business owners should keep in mind is that buyouts sometimes occur before a key employee’s, an executive’s, or even their own holding period is up.

As a result, the favorable ISO tax treatment may not be available.  Instead, that key employee or executive is then required to pay more in taxes, since they will be taxed at the income tax rate.

On the bright side for the selling business, the company may be eligible for a deduction generally equal to the amount of income that is recognized by the individual.

However, it is very possible that the company may not be able to take advantage of all the resulting tax deductions in the year of sale because it doesn’t have sufficient taxable income for that year.

As a result, a seller may attempt to negotiate for extra purchase price to recoup the money lost due to the restrictions on deductions. This is met with varying degrees of success.

Conclusions

So to answer the question of which type of equity interests your company should grant, at Leo Berwick, we’d say, “it depends on you (and the tax code).”

If your company is structured as a partnership or LLC, profits interests are a possibility.  In order to issue ISOs, the business must be a corporation.

As a result, the issue of whether to grant profits interests or options is something to take into consideration when deciding the type of entity to use to hold your business.

For more on different ways to structure businesses, read “Choice of Entity.”

[1] Rev. Proc. 2001-43; but receipt is taxable if Rev. Proc. 2001-43 applies.

[2] The upper tax bracket could change from 37% to 39.6% if Biden’s proposed legislation is enacted.