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September 24, 2024
by Nicholas P. Flint

Companies often grant awards of equity or equity-like benefits to their employees and service providers, providing an actual or perceived ownership interest in the company in order to attract and retain talent, to incentivize performance by existing service providers, and to align the interests of the company and its key personnel.

There are a variety of options when it comes to incentive equity, all of which have legal and tax implications to both the granting company and recipient service provider. This article provides an overview of the different types of equity compensation commonly granted by companies, including profits interests, restricted stock, stock options, phantom stock, and performance bonuses.

Profits Interests 

Profits interests can be awarded to service providers by any entity treated as a partnership for tax purposes, including general partnerships, limited partnerships, limited liability partnerships, limited liability limited partnerships, and—most commonly—limited liability companies (LLCs) with more than one member that have not elected to be treated as a corporation for tax purposes.

Profits interests represent the right to participate in the appreciation in value of the company from the date of the grant to the date of ultimate disposition by the service provider. To accomplish this, the company will set, at the time of the profits interest grant, a threshold or hurdle amount (typically the value of the company at the time of the grant) which must be met before the service provider holding profits interests may participate in distributions. If structured properly, an award of profits interests is not a taxable event to the service provider, as the value of the award at the time of the grant is effectively $0.

It is common for profits interests to vest over time in accordance with a schedule, whether tied to the duration of services provided to the company, the company’s achievement of performance milestones, or both. Time or performance-based vesting schedules serve to align the interests of the company and the service provider, and maximize the benefit to using incentive equity.

Restricted Stock

Restricted stock can be issued by a corporation to its employees or service providers. Because restricted stock is actual stock of the corporation, the employee or service provider becomes the record owner of the stock on the grant (or vesting) date, potentially entitling the service provider to voting, dividend, and other shareholder rights. However, the stock is subject to certain restrictions, including that the stock may be forfeited or repurchased upon the service provider’s termination of employment, and that the stock may not be sold, transferred, or assigned by the service provider to any third party.

One of the primary advantages to the use of restricted stock is the retention effect on service provider recipients. However, the downsides to restricted stock include the fact that service providers must generally pay tax on the value of the stock at the time of the award and that grants of actual stock can dilute other existing shareholders of the company.

Stock Options

Stock options can be granted to service providers or employees of corporations and entitle the holder to purchase a specified amount of the company’s stock at a specified price or “exercise price”. The option must be exercised during a specific period of time and only once the option vests (which may be subject to a vesting schedule as with profits interests and restricted stock). The exercise price is typically calculated based on the value of the stock on the option grant date. Unlike restricted stock, because no stock is actually issued on the grant date, the recipient is not entitled to participate in dividends or voting, and there is generally no taxable event to the service provider.

The two types of stock options are non-qualified stock options (NSOs) and incentive stock options (ISOs) which provide certain tax benefits to the recipient. Non-qualified stock options may be granted to employees or service providers regardless of employment status, while incentive stock options may only be granted to employees.

Phantom Stock

Phantom stock involves a contractual obligation of a company to make a cash payment to a service provider equal to the value of a specified amount of equity or shares of stock upon the occurrence of certain specified events. Phantom stock is not actual stock in the company, but rather a contractual right to receive a payment as if the recipient held actual stock. As with the other incentive equity options discussed in this article, phantom stock is often subject to time and/or performance-based vesting.

There are several advantages to using phantom stock awards for equity compensation, most notably of which is the lack of dilution of existing shareholders or the giving up of voting, dividend, and other shareholder rights. Additionally, the recipient is generally not taxed on the award unless and until the cash payment is actually received, at which point the service provider typically has received funds sufficient to cover the tax burden.

Performance Bonuses

Similar to phantom stock in that it is not a grant of actual equity, performance bonuses are the most commonly used form of incentive “equity” to attract and retain employees and service providers. Performance bonuses are contractual obligations of a company to make cash payments as periodic bonuses and can be based on the service provider’s achievement of certain performance milestones, the company’s revenues or profits, a number of other performance-based metrics.

As with phantom stock, performance bonuses do not dilute existing shareholders, and the tax implications to the service provider are similar due to the timing of payments. An added benefit of performance bonuses includes the fact that a separate incentive equity plan is typically not required, with the employee’s bonus rights generally being outlined in their employment agreement.

Identifying and implementing the equity incentive plan that best suits your business and its employees can be a complex matter involving a variety of legal and tax considerations, and it is therefore important to enlist the aid of experienced corporate counsel and tax professionals throughout the process.

Nicholas Flint is partner with Flint, Connolly & Walker, LLP who represents domestic and international clients in a variety of corporate and transactional matters, including mergers and acquisitions, joint ventures, private equity and venture capital transactions, financing and lending arrangements, and debt and equity offerings. In addition, Mr. Flint serves as a general business and legal advisor to his clients, counseling on matters such as corporate governance, executive compensation, regulatory compliance, and commercial contracts.