Page 11 - Business Insights Technology Industry

EQUITY-BASED deduction for compensation on the corporate includes a right to the equity of the business
COMPENSATION companies, these options are very rarely used. way, the employee gets to share a percentage
level. For private, early stage technology prior to the date of the grant. Said another
equal to the grant of all of the value of the
Restricted Stock/Restricted Stock Units: business prior to the grant. A capital interest
Restricted stock can be considered the sister is determined by the liquidation rights on the
of ISOs. Restricted stock refers to shares date of the grant. If the employee is entitled
typically awarded to an executive-level to assets upon liquidation, then it is a capital
employee. The shares are often subject interest.
to vesting schedules, with the employee
losing any shares that haven’t been vested. A capital interest will give rise to a deduction
The employee will recognize income when to the business equal to the value of the newly
the shares vest and are no longer subject created capital account, and the employee
to forfeiture; the company will recognize will recognize ordinary income equal to the
a deduction at the same time. There are deduction taken by the business.
some legal differences in contractual nature
between restricted stock and restricted stock Profits Interest: The IRS broadly and
units; however, their tax treatment is mostly foolishly defines a profits interest as “any
the same. interest other than a capital interest.” In
practical terms, a profits interest represents
n order to attract and retain qualified Incentive (Qualified) Stock Options
I talents, technology companies often (ISO): ISOs for established and publicly- Companies that issue equity based an interest in the future appreciation of a
compensation will need to make sure that partnership from the date of grant. From the
will use equity based compensation. traded companies are typically offered the formalities of such are in place. The date of the grant, the employee will share in
This method of compensation is beneficial for to executive-level employees and have company will require a written plan with the profits and losses of the partnership equal
technology companies for several reasons: significant restrictions on their exercise and board approval for these shares. Typically, to his or her percentage grant and begin to
grant. However, for early stage technology they should only represent a small pool of create a capital account which represents the
1. There is no out-of-pocket cash cost. companies, it is more standard for this class the overall equity of the company. Many appreciation the partnership from the date
2. It aligns the goal of growth between the of option to be offered to all employees, companies have run into issues where their of grant. An important feature of a profits
employees and the company. not just executives. Companies are looking plans or grants were not properly written interest is that the grantee has no liquidation
to assist in creating the best potential tax
3. The vesting schedule allows companies to outcome for their employees, and the use and approved, leading to taxation issues and rights on the grant, only on the future
multiple lawsuits over these grants.
appreciation.
retain talent and minimize turnover. of ISOs versus NQSOs allows for minimal
4. Years of this practice have made it the ordinary income and potential for large Partnerships & LLCs Taxed as Given that at the date of the grant, the
norm for many technology companies. capital gains on disposition. These options Partnerships employee is not being given anything other
do not offer any corporate-level deduction than a right to future growth, the business will
The exact mechanics of equity based for the company, and as such, do not have Unless an LLC elects to be treated as a not recognize a deduction for the grant and
compensation depend largely on how the any tax effects on the grant to the employee. corporation, the entity will default to being the employee will not have any income.
company is legally structured and how the treated as a partnership. In early startup
company is taxed. While both corporations Non-Qualified Stock Options (NQSO): years, a partnership structure benefits Different business structures allow for
and LLCs can use equity compensation, the NQSOs are more common options that can owners since the losses will pass through to different methods of rewarding employees
arrangements are very different for each, be granted to both employees and other their personal tax returns, allowing them to with equity compensation, each with different
particularly in regards to the taxation. service providers. These options will have a potentially take these losses against other tax effects for the businesses. On top of
strike price (how much the shares will cost income. Additionally, many investors enjoy compensating employees for their hard work,
the employee) and often an expiration. The the benefits related to a single layer of equity based compensation can often align
Corporations & LLCs Taxed as
Corporations difference between the strike price and the taxation rather than the additional tax costs the goals of the business with the goals of
value of the shares represents the taxable of an incorporated structure. Partnerships the employees to help maximizing value of
With an LLC taxed as a corporation, there portion of the grant, known as the bargain differ greatly in both the nature and planning the firm and to encourage growth. With the
is no difference in the taxable effect on element. Neither the corporation nor the opportunities for equity based compensation. multitude of options it is important for all
the business as if it were organized as it employee recognize a taxable transaction on There are two primary methods for equity businesses to make sure they understand their
as a traditional corporation. Corporations grant; the taxable event is during exercise. based compensation in a partnership. choices and how these different forms of
generally have three different methods of The difference between the option strike equity compensation will affect their taxable
compensating employees. price and value when exercised represents Capital Interest: A capital interest refers to a situations.
compensation to the employee and a grant of partnership equity to an employee that
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