Equity Compensation Arrangements in a Nutshell

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1 Equity Compensation Arrangements in a Nutshell Equity compensation is an important tool that can be used by any business to attract and retain service providers deemed important to the long-term success of the business. Equity compensation is non-cash compensation that can take any of several forms, including most often options to acquire equity and restricted equity. It can be used by corporations, limited liability companies and partnerships. Thus, for these purposes, equity means corporate stock or an ownership interest in a limited liability company or partnership. This discussion does not address equity-based compensation arrangements such as phantom equity or appreciation rights that do not provide the service provider with ownership rights, nor does it consider the financial accounting aspects of equity compensation. Equity compensation typically is used by a going concern to incentivize key personnel to work toward achievement of long-range company goals. Equity compensation can also be used when a person has expertise and services but no capital to contribute to a fledgling business. This material provides a summary of the tax consequences of the use of equity compensation, to both the service provider and the business providing the equity. The two most common forms of equity compensation are options to acquire stock (or other equity) and restricted stock (or restricted equity). As a host of legal, accounting and tax issues are associated with equity compensation, proper planning is critical to the implementation of any equity compensation plan. Consequently, it is imperative that a company seek legal and accounting advice prior to implementing any such plan. Equity Options An equity option is a right to an interest in the equity of a business for a specified price (the exercise price ). The right to exercise the option generally accrues, or vests, over a period of time or upon the occurrence of an event, such as the sale of the issuing company. In

2 theory, vesting over time creates an incentive for the option holder to remain with the company until the option vests and becomes exercisable at a time when the exercise price is less than the fair market value of the underlying equity. There are two types of equity options: incentive stock options and non-qualified equity options. Incentive Stock Options Only a corporation can issue an incentive stock option ( ISO ), and ISOs can only be issued to employees of the corporate service recipient. Thus, an ISO cannot be issued to a director that is not an employee of the issuing corporation nor to any other independent contractor. In addition, in order for a stock option to qualify as an ISO, the option must comply with a handful of conditions set forth in the Internal Revenue Code. One such condition requires that any plan to issue ISOs be approved by the shareholders of the issuing corporation within twelve months before or after the date the plan is adopted by the corporation s board of directors. Another condition requires that the exercise price of any ISO be at least equal to the fair market value of the underlying stock at the time the option is issued. A purported ISO that fails to meet the statutory requirements will be treated as a non-qualified equity option. The mere grant (or vesting) of an ISO has no federal (or state) income tax consequences to either the corporate employer or the employee. Likewise, the exercise of an ISO has no federal (or state) income tax consequences. Exercise of an ISO can, however, have alternative minimum tax ( AMT ) consequences, since the excess of the fair market value of the underlying stock over the exercise price is an adjustment that must be taken into account for AMT purposes. If stock acquired upon exercise of an ISO is held for at least (i) two years after the ISO was granted and (ii) one year after the ISO was exercised, any subsequent taxable disposition of the stock will give rise to long-term capital gain (loss), in an amount by which the sales

3 proceeds are greater (less) than the exercise price. If this holding period requirement is met, the employer never gets any deductions associated with the stock transfer. If the stock is disposed of before it is held for the requisite period, that is, if a disqualifying disposition occurs, the stock option will lose it characterization as an ISO, and will instead be treated as a nonqualified equity option, the tax treatment of which is described below. Non-Qualified Equity Options In contrast to an ISO, a non-qualified equity option ( NQEO ) can be issued by any service recipient, whether a corporation, a limited liability company or a partnership. Also in contrast to an ISO, a NQEO can be issued to any service provider. While greater flexibility is provided regarding NQEOs as opposed to ISOs, care must be taken in any plan providing for NQEOs to ensure that the NQEOs comply with the safe harbor provisions of the regulations under Section 409A, which imposes certain penalty taxes on service providers who are entitled to receive payments under non-qualified deferred compensation arrangements. Among other things, this means that the exercise price of an NQEO may not be less than the fair market value of the underlying stock (or other equity) of the service recipient on the date the NQEO is granted and, further, that the number of shares (or other equity) subject to the NQEO must be fixed on the date of grant. Except in the rare case in which a NQEO has a readily ascertainable fair market value (i.e., is publicly traded), the grant (or vesting) of a NQEO has no federal (or state) income tax consequences. When a NQEO is exercised, however, the service provider recognizes ordinary income to the extent the fair market value of the underlying equity exceeds the exercise price, if any, of the NQEO. This ordinary income is wages for federal (and state) income and employment tax purposes. This means that, when a NQEO is exercised resulting in income to the service provider, the service recipient will have both income and employment tax withholding obligations (as well as employer s share employment tax obligations). This also

4 means that, since the particular payment of wages is made in stock or other equity rather than cash, arrangements will have to be made to withhold the appropriate income tax and the employee s share of employment taxes from other cash compensation paid to the service provider. Provided the service recipient files the appropriate forms (W-2 or 1099) to report the compensatory payment, the service recipient is entitled to a deduction in an amount equal to the ordinary income realized by the service provider, for the same tax year in which the ordinary income is realized by the service provider. Once a NQEO is exercised and the service recipient realizes the ordinary income associated with exercise of the NQEO, any subsequent taxable disposition of the underlying equity will give rise to capital gain (loss), measured by the amount by which the sales proceeds exceed (are less than) the service provider s tax basis for the equity. The service provider s tax basis ordinarily will equal the exercise price, if any, plus the ordinary income realized upon exercise of the NQEO. If the underlying equity is held for more than one year after exercise of the NQEO, the resulting gain (loss) on disposition will be long-term capital gain (loss). Restricted Equity The holder of an option to acquire equity, whether the option is an ISO or a NQEO, lacks the state law rights of a shareholder. Thus, the holder of an ISO or a NQEO does not have voting rights or share in equity distributions (e.g., dividends). For this reason, it is sometimes appropriate to issue equity to key service providers. In order to motivate the service provider to continue to perform, such equity is made both nontransferable by the holder and subject to a risk of forfeiture if the holder s employment is terminated within some period specified at the time the restricted equity is issued. Hence the term restricted equity. At the time restricted equity become transferable or nonforfeitable (i.e., when the right to the equity vests), the service provider realizes ordinary income equal to the excess of the fair market value of the equity, on the date the equity vests, over the amount, if any, paid for the

5 equity. Such income is wages for federal (and state) income and employment tax purposes. Thus, vesting triggers income and employment tax obligations for the service recipient, and the service recipient s deduction for the compensation paid to the service provider will hinge upon the filing of appropriate forms (W-2 or 1099) to report the payment. Since non-cash compensation is being paid, the service recipient will need to arrange with the service provider to withhold the required income and employment taxes from other cash compensation paid to the service provider. Once the restricted equity vests and the service provider realizes ordinary income, a subsequent taxable disposition of the equity will create capital gain (loss), to the extent the sales proceeds exceed (are less than) the basis of the equity (ordinarily the price paid, if any, plus the income realized on vesting). The capital gain (loss) will be long-term capital gain (loss) if the equity is held for more than one year after vesting. If the service provider anticipates that the value of the restricted equity will escalate before the equity vests, the service provider can file a section 83(b) election to minimize the ordinary income resulting from receipt of the equity. Any section 83(b) election must be made within thirty (30) days after the equity is issued, so the service provider does not have a great deal of time to decide whether to make the election. Copies of any such election must be filed within such 30-day period with both the Internal Revenue Service and the service recipient. It should be noted that a section 83(b) election will not only lock in the service provider s ordinary compensation income and commence the holding period of the equity for capital gain purposes, it will also trigger the service recipient s federal (and state) income and employment tax obligations. The service provider should be aware that, if equity is forfeited after a section 83(b) election is made, the service provider s deduction with respect to the forfeited equity will be limited to the amount, if any, paid for the equity and not recouped on forfeiture, and any such deduction will be a capital loss rather than an ordinary loss.

6 Special Rules Applicable to Partnerships Interests in partnerships, whether state law partnerships or limited liability companies taxed as partnerships, come in two varieties: capital interests and profits interests. If a partnership issues an interest in partnership capital in exchange for past, present or future services, the recipient of the interest is taxed on the receipt of the interest in an amount equal to the fair market value of the interest (less the amount, if any, paid for the interest). As in the case of other equity interests issued to service providers, the income that results to the service provider will be treated as wages for income and employment tax purposes. If the interest in partnership capital is subject to vesting (i.e., the interest is restricted equity), the taxable event will be deferred until vesting occurs, unless a section 83(b) election is made to accelerate the taxable event. On the other hand, if a profits interest is issued, there are no tax consequences to either the recipient or the partnership. According to applicable IRS guidelines, whether a partnership interest is a profits interest rather than a capital interest depends on several factors, including whether the recipient of the interest would be entitled to any liquidation proceeds if the partnership were to be liquidated immediately after the issuance of the interest. If the recipient would receive anything on liquidation, the interest is a capital interest, and the issuance of the interest is a taxable event unless the interest is restricted. If not, the interest is a profits interest. Proper use of equity compensation is important in attracting and retaining service providers that may be key to long-term success. Our attorneys have many years of experience in advising businesses concerning the pros and cons of equity compensation as well as in drafting the appropriate plan documents associated with equity compensation arrangements.

7 DISCLAIMER: The material contained herein is for general information purposes only, and is not intended to constitute tax advice. If you are interested in the subject of this material, we encourage you to contact us or other independent tax advisor to discuss the potential application of this material to your situation. CIRCULAR 230 DISCLAIMER: The foregoing material was not written or intended to be relied upon, nor can it be used, by any taxpayer for the purpose of avoiding federal tax penalties. This disclaimer is made to comply with Circular 230, which governs practice before the Internal Revenue Service. For assistance or further information, please contact: NAME TITLE LOCATION TELEPHONE James A. Attorney Louisville Nitsche G. Alexander Hamilton Attorney Louisville DISCLAIMER: We welcome the receipt of . You should be aware, however, that the act of sending to Wyatt, Tarrant & Combs, LLP or a specific attorney at the firm does not create an attorney-client relationship, and that you are not entitled to have us treat the information contained in an as confidential if no attorney-client relationship exists between us at the time we receive that . An attorney-client relationship cannot be created until we consider potential conflicts of interest and agree to that relationship. If you are interested in establishing an attorney-client relationship, we invite you to call or visit with one of our attorneys for that purpose. THIS IS AN ADVERTISEMENT