PI Global Investments
Private Equity

Nothing Phony About Using Phantom Equity as Compensation—Part 1

Bloomberg Tax

When it comes to compensating an employee with a grant of equity, it is not a perfect world when considering the impact of taxation. A perfect world when granting equity compensation from a tax perspective would include at least the following:

  • At the grant date, and as the grant vests, the employee receives no taxable income or gain;
  • Upon a change in control, the employee receives the full value of the equity granted—for example, there’s no strike price or participation threshold subtracted from the proceeds;
  • The proceeds received are taxed only upon a change in control, which is when the employer company is acquired, and the shareholders can cash-out their equity for dollars;
  • The entire payout is long-term capital gain to the employee; and
  • The employer can deduct the entire amount of the payout to the employee.

This perfect tax world for equity compensation doesn’t exist, but phantom equity can help alleviate the shortcomings of other forms of equity compensation. One of the biggest advantages of phantom equity is that it’s flexible and can be customized to numerous situations. Also, it can be used as a standalone measure to reward employees or to supplement other equity grants to ameliorate their shortcomings.

To understand the benefits of phantom equity, it’s helpful to summarize the existing tools for providing equity compensation.

Equity Grants

First, equity grants—such as a grant of stock in a corporation or units in a partnership—are taxable as ordinary income when the recipient is considered to become the owner of such equity. The employee is considered to be the owner for tax purposes when the equity vests, or in tax parlance, is “not subject to a substantial risk of forfeiture.” See generally IRC Section 83. The amount of ordinary income is equal to the fair market value when the employee becomes the owner of the equity. At the point when the employee becomes the owner of the equity, it’s as if the employer made a cash payment to the employee and the employee then purchased the equity.

Like any purchase of stock or units, a subsequent sale of such equity is taxable as capital gain. The amount of the capital gain on the subsequent sale is measured by the appreciation from the time when the employee included the equity in ordinary income, which is the time when the employee is deemed to have purchased the equity. If the equity grant vests over time, then as each portion of the grant vests, such portion will be taxable as ordinary income to the recipient. Similarly, when the recipient later sells the equity, then any appreciation measured from each of the respective vesting dates is taxable as capital gain.

If the stock appreciates from the grant date by the time it vests, then the employee’s ordinary income recognition will likewise be higher. To address this issue, the IRC allows a recipient to elect under Section 83(b) to include the full fair market value of the grant on the grant date even though the employee will not own the equity until it vests according to the vesting schedule.

On the employer side, as the employee recognizes ordinary income, the employer is entitled to a corresponding deduction for the amount of such ordinary income, unless disallowed by another specific IRC section such as Section 162(m) for public corporations paying more than $1 million in compensation or $280,000 for “golden parachute payments,” which are limited situations. See Section 83(h). When the employee receives capital gain on a subsequent sale of the equity the employer is not entitled to a deduction.

ISOs and NSOs

Options to purchase equity are another equity compensation tool. A grant of options is taxable similar to the preceding rules for stock/unit grants only if the option has a readily ascertainable value and it doesn’t qualify as an incentive stock option under Section 421. Also see Sections 83(e)(3), 83(e)(4). In tax parlance, options that are not ISOs are referred to as nonstatutory stock options.

NSOs rarely have an ascertainable value upon grant and therefore are generally taxable as ordinary income whenever the NSO is exercised, in an amount equal to the difference between the underlying equity’s fair market value on the exercise date minus the strike or exercise price on the option. See Rev. Rul. 78-185. Also, if the strike price is less than fair market value of the underlying stock, the IRS might be able to characterize the grant as a deferred compensation arrangement.

In the stock-option world, ISOs are treated differently from NSOs. Specifically, stock acquired via an ISO can benefit from long-term capital gain rates when subsequently sold. However, ISOs have very particular rules, including that:

  • The stock acquired through the exercise of an ISO can’t be sold until one year after the anniversary of the option exercise and the two-year anniversary of the grant date;
  • The strike price of the option must equal the fair market value of the underlying stock on the grant date; and
  • Only C corporations can issue ISOs.

In practice, due to the nuances of intricate rules, which aren’t aligned to the realities of the practical world, ISOs rarely achieve the intended goal of providing the benefit of capital gain taxation to an employee. For instance, when an ISO is exercised the spread, which is defined as the difference between the fair market value of the stock minus the strike price, it’s treated as an adjustment for alternative minimum tax purposes. This typically means that the employee will owe alternative minimum tax at a 28% rate on the spread, and this in turn usually motivates the employee to pay for such tax by selling the stock even though the sale will be a disqualifying disposition, which in turn causes the employee to be taxed at ordinary income rates on the spread.

Partnership Profits

Partnerships, including limited liability companies that are taxed as partnerships, can issue profits interests, which are like a hybrid of straight equity and options. The employee is entitled only to the appreciation in the value of the equity from the grant date.

When there is a subsequent change in control, the amounts payable to the employee are then calculated by tracking only the appreciation from the grant date of the profits interest. Generally, profits interest held for at least one year will qualify for long-term capital gain. See generally Rev. Proc. 93-27 and Rev. Proc. 2001-43.

However, please note that the profits interests of private equity companies, real estate funds, investment partnerships, and venture capital companies are generally governed by Section 1061, which was added by the Tax Cut and Jobs Act of 2017 and, among other things, requires that the employee hold the profits interest for at least three years to receive long-term capital gain treatment.

In Part 2 of this article, we’ll discuss the challenge of transferring equity’s full value to an employee looking to recognize long-term capital gain treatment.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Steve Lueker is a partner with Moses & Singer LLP’s tax practice.

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