• Equity-Based Compensation: The Friend and Foe of Startup Companies
  • March 18, 2016
  • Law Firm: Lerch Early Brewer Chartered - Bethesda Office
  • Many startup companies face the important decision of how to compensate key employees. Generally, startups do not have the cash flow to pay market salaries. As such, companies must design creatively their compensation programs to incentivize and retain key employees.

    Young businesses commonly use equity-based compensation to supplement a less-than-market salary paid to a new hire. Equity-based compensation includes options, restricted stock units, stock appreciation rights, and performance shares. Partnerships may even grant equity-based compensation in the form of capital interests and profits interests. Equity-based compensation also allows employees to share in profits, and encourages long-term employment through the grant of restricted awards, as the award must vest before the employee receives income.

    However, a young business should be mindful of the federal and state tax responsibilities of both the business and the employee when structuring its equity-based compensation program. The tax implications of equity-based compensation are more burdensome than merely withholding taxes from a base salary.

    Timing of the Taxation for Equity Awards

    The timing of the award and when it is subject to tax present some problems. If the business grants a restricted award, then generally the award is not subject to tax until the award vests. This makes sense on its face: if you have no right to an award, why should you pay a tax on it? There are exceptions to this general rule.

    For restricted stock awards, the Internal Revenue Code allows the employee to make an election within 30 days of receiving the award and pay ordinary income tax on the entire award when it’s granted rather than when it vests.

    This is a particularly attractive option for a startup company where the value of the stock is expected to increase exponentially (and the employee would pay capital gains tax, not ordinary income tax, on any increase in the value from grant to vesting). The company receives an income tax deduction with respect to the restricted award in “an amount equal to the amount included” in income by the employee. As such, the employer receives a deduction on the vesting of the stock if there is no election by the employee, and upon the granting of the stock if the employee elected to pay ordinary income tax when it was granted.

    Tax Treatment of Equity-Based Compensation

    The next question is, of course, how much are the taxes? The equity-based compensation will be subject to ordinary income tax and/or capital gains tax. The tax treatment of the equity-based compensation varies on the type of award, and a portion of the award could be subject to ordinary income tax and a portion subject to capital gains tax. While the company should consider the tax implications of the equity compensation prior to grant, these taxes are generally known to employees and should not shock them.

    There are a few sections of the Internal Revenue Code that may upset employees if overlooked in the development of an equity-based compensation program. In particular, the complex Section 409A deferred compensation rules can lead to a severe penalty for non-compliance. These rules apply when an individual receives a right to payment to be made on a future date (e.g., receiving an option without paying fair market value). Section 409A imposes a 20% tax on nonqualified deferred compensation that does comply with the various rules regarding deferrals and distributions.

    This tax is on top of the ordinary income tax otherwise owed. Some states impose their own 409A taxes. An employee could face a tax of more than 60% for non-compliance. Although the employer does not face the tax, a Section 409A tax is unlikely to help employee morale.

    Equity-based compensation is almost a necessity for a startup. However, it imposes administrative burdens on the timing of taxes and can result in significant penalties if not in compliance. The company should consult with its tax professionals before proceeding with any equity-based compensation.