You are always looking for creative ways to retain your top employees. One option is to offer valued employees equity in your business. However, not all types of equity incentives are created equally or are available in all situations.
How Can You, As A Business Owner, Keep Your Valued Employees?
The backbone of the most successful businesses consists of talented employees who work tirelessly, investing their skills and time to help grow and sustain the viability of their employers. Finding such employees can be a difficult task that is both costly and time intensive. Once you have successfully groomed an employee, the next challenge for you is retaining that employee. The retention of valued employees is not a new or foreign concept. Business owners have always tried to come up with creative options to encourage employees to continue their employment.
Although there are many options available to you to retain talented employees, the most typical incentives offered are promotions, pay raises, and large year-end bonuses. However, these options may not always be possible given the financial position of your business and, in some instances, may not serve as an effective incentive for a valued employee. For decades, corporations have offered equity compensation awards such as stock options in order to retain valued employees in a cost-effective manner. Such equity compensation awards have proven to be a viable option for corporations.
Are Equity Compensation Awards In An LLC Permitted?
As the use of the corporate structure has slowly started to fade out, making room for more advantageous business structures such as a limited liability companies ("LLC") and S-corporations, regulators have recognized the need to permit these evolving business structures to use various types of equity compensation awards. Consequently, much like a corporation, your LLC is permitted to grant valued employees both equity interests and options to acquire equity interests in exchange for the future or past performance of services. However, equity compensation awards offered in the LLC context can be more complex than those offered in the corporate context.
What Equity Interest Award Is The Right Fit For Your LLC?
Your LLC can generally offer two types of equity interests: "capital interests" and "profits interests." You should evaluate each type of equity interest in order to determine which will best accomplish your goals since they are not created equally.
A "capital interest" is an ownership interest in an LLC that gives a valued employee a pro rata share of the value of your LLC as of the date the interest is granted, and in the future profits and appreciation in the value of your LLC. Essentially, the granting of a capital interest shifts a portion of your equity interest in your LLC to your employee as of the date such interest is awarded. Typically, the fair market value of such a capital shift (less any amounts paid by the employee) will be taxable to your employee at ordinary income tax rates. However, determination of the fair market value of such capital interest is dependent upon when your employee actually receives legal title to the capital interest (i.e., when the interest vests), which is discussed in more detail below. In addition, any amount of income that is taxed to your employee will be treated as a deductible business expense of your LLC.
A "profits interest" is purely an economic interest in the future profits and appreciation in the value of your LLC following the date of grant. Contrary to a capital interest, your employee would not receive a pro rata share of the value of your LLC as of the date the interest is granted, but rather would receive only a pro rata share of the future profits and appreciation in value of your LLC that arise after the date such interest is awarded. Therefore, the grant of a profits interest would not be subject to any capital shifting regulations or limitations as required by the granting of a capital interest. As such, the grant of a profits interest generally will not be taxable since the fair market value of such interest would typically be zero at the time of its grant.
At first glance, the capital interest has a clear downside since you have to give up a portion of your equity interest in your LLC. However, the granting of a profits interest typically does not provide the employee receiving the award with many ownership rights compared to that of a capital interest. Additionally, it is possible that your employee may want more than just an economic interest in the future profits and appreciation of your business—that is, your employee may actually want a voice in your business.
How Can You Structure An Equity Compensation Award?
Equity compensation awards can be structured in several different ways, all of which can have significantly different results for both you as the business owner and your valued employee. You could structure the equity compensation award so that the granted equity interest vests immediately, over a set period of time, or upon the occurrence of a specified event. On the other hand, instead of actually granting an equity interest, you could grant your employee an option to purchase an equity interest in your LLC.
Structuring an equity compensation award whereby the equity interest vests over a set period of time or upon the occurrence of a specified event not only delays the dilution of your equity interest in your LLC, but also encourages your employee to continue working for your LLC until such time as the awarded equity interest has fully vested. In addition, any tax for which your employee would be responsible would be deferred until the equity interest vests, in part or in whole, unless either your employee makes an election under Section 83(b) of the Internal Revenue Code or the interest is deemed vested upon the grant date by the Internal Revenue Service (this discussion is beyond the scope of this article).
Conversely, you could grant your employee an option that entitles the employee to purchase an equity interest in your LLC at a purchase price that is at least equal to the fair market value of such LLC interest on the date the option is granted. Structuring an equity compensation award as an option would encourage your employee to continue to perform services for you in the hope that the value of your business will increase exponentially before the employee exercises the option. In addition, similar to an unvested capital interest, the option will not be taxable to your employee upon its grant but, rather, would be subject to tax on the date the option is exercised.
There are many ways that you can encourage your most valued employees to continue to perform services for your business. However, if you want to retain the employees without otherwise giving them a raise or paying large year-end bonuses, then you may want to explore the possibility of granting equity compensation awards. However, you need to be mindful of the different options and their related tax consequences.
© 2021 Ward and Smith, P.A.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.