A common business transition planning strategy involves bringing a key employee into the ownership group well before the ultimate exit. This is a common scenario in the construction industry to ensure continuity and succession.
Imagination is often the only limitation in structuring these arrangements. Each option presents different tax considerations. A few include:
Consider the type of business entity
Although many types of entities exist, C corporations, S corporations, partnership-taxed entities (essentially LLCs) and sole proprietorships are often encountered. Some strategies that work for one or more of these business entities might not work for another. For example, a common strategy used with LLCs is a “profits interest” – i.e., the grant of an interest in future profits without making a grant of current capital of the business. Unfortunately, profits interests are not available for corporations (especially S corporations due to the one-class-of-stock rule). Also, incentive stock options are not available for LLCs and sole proprietorships.
Taxation today vs. taxation in the future
Profits interests can be useful tools because, if properly structured, they do not cause a tax event at the time of the grant. Arrangements for corporate entities can be structured so that they do not cause a taxable shift today, but those often come in the form of executive compensation plans. These incentive plans differ from profits interests because compensation plans provide for bonuses or cash instead of a true upside ownership stake. Compensation plans can also create other unintended consequences at the time of a change in control of the company if the payout is treated as a “golden parachute” for tax purposes. Those consequences can include increased taxes and complexities.
Paying the tax on a true equity grant
If the company makes an equity (or capital) grant to a key employee, that employee will usually be taxed at ordinary rates on the value of that grant. If the key employee does not have other funds from which to pay the tax on the grant, the key employee may look to the company for additional money. A common workaround is for the company to reduce the equity grant and couple it with a cash bonus. This may not be desired because reducing the equity grant may make the later transition more complex. Additionally, the employer may not have the cash available to cover the bonus; and both the company and the key employee should remember the bonus will need to be grossed-up to take into account the taxes on the bonus itself.
Accelerating vs. deferring taxation
If the business grants an ownership stake to a key employee but then conditions that grant on future events or performance, those restrictions can cause the grant to be taxed in the future. This would mean the income event to the key employee would happen later in time. This might be desired to eliminate the tax payment issue discussed above, but the collateral consequences would need to be weighed. For example, the company would not be able to deduct the amount of the grant until the key employee is required to take the amount into income. Furthermore, if the key employee wants to later sell the interest and obtain long-term capital gain treatment (which under current law affords a lower overall tax rate), the key employee will want to start the one-year holding period clock running sooner rather than later.
Section 83(b) elections
One way to accelerate the taxation and start that clock running is for the key employee to make an election under Section 83(b) of the Internal Revenue Code to cause the grant to be taxed today, rather than waiting until the restrictions lapse in the future. If filed timely, the election will have the desired effect of causing the granted equity to be included in the employee’s income at the value of the property at the time of the grant. The company will obtain a compensation deduction, and the employee will need to consider the tax consequences described above. The trade-off is that the key employee can start the clock running on the long-term capital gain requirements. It should be noted, however, that not all equity grants or similar devices can make this election.
In conclusion, when a business looks to bring a key employee into the ownership ranks, whether for transition or for incentive, the features are often limitless. Some options fit certain circumstances better than others. Above all, however, both the business and the employee should weigh the tax consequences and benefits of the various options when making the choice.
Column first appeared in the Daily Journal of Commerce on June 14, 2016.