Equity Compensation Alternatives for Technology Founders
August 10, 2023
In the beginning stages of a technology company’s formation – and sometimes even into its maturity – the options for ownership and structuring can get complicated. In some cases, having ownership in a company may not be as lucrative as maintaining employee status in the short run. However, foregoing some tax-preferred employee benefits may be worth the trade-off for an ownership stake. Here, we break down two alternatives for equity compensation, their practical implications and their tax considerations.
Capital Interest vs. Profits Interest
While rewarding employees with stock largely takes place in the corporate context, the same can occur in a partnership or an LLC. A partnership (or an LLC that is taxed as a partnership) can reward employees with capital interest or profits interest. Capital interest provides the employee with a share of the current value of the partnership, much like the transfer of corporate stock. On the other hand, profits interest provides the employee with a share in future profits, with an agreement specifying the threshold amount of the current value which would not be transferred as part of the profits interest. In both cases, the individual receiving the interest could no longer be considered an employee, but rather would become a partner.
The transfer of either capital or profits interest for services is taxable to the extent that the value of the interest is greater than the amount paid for such interest. Regarding profits interest, the value is deemed to be zero because the liquidation value at the moment of transfer would be zero, as no profits have been earned. Taxation occurs when the interest is not subject to a substantial risk of forfeiture. Often, amounts transferred require that the recipient either continues to render services for a stated period of time, a performance condition is met or both. These conditions are known as a substantial risk of forfeiture.
When property transfers subject to a substantial risk of forfeiture are made, the employee can elect to pay tax upon receipt of the property rather than waiting for the substantial risk of forfeiture to be satisfied. This is known as a section 83(b) election. Because profits interest is valued at zero, there is no income to be recognized on receipt of such interests. In fact, the IRS considers the employee to have made such an election, even if that does not happen, if certain conditions are met. Virtually all advisers recommend that the recipient of such partnership interests make such elections, commonly known as protective section 83(b) elections, in case those conditions are not met.
Partner vs. Employee Benefits
Even though an individual receiving partnership profits or capital interest can no longer be treated as an employee, participation in the partnership’s retirement and other fringe benefit plans may continue. The partner can continue to make elective deferrals in a 401(k) plan, as well as share in partnership matching and other contributions.
While a partner can continue in the partnership’s insured health benefit plans, the premium cost of such a plan would be included in their income and deductible by the partner if certain conditions are met. One of these conditions is that the partner cannot have an employer-subsidized health benefit plan available, such as one through the employer of a spouse or dependent. A partner cannot participate in a self-insured health arrangement, such as an HRA. However, large partnerships maintaining self-insured health plans may exhibit the risk-shifting and risk-distribution characteristics of insurance, enabling partners to participate.
While some fringe benefits are available to partners, others are not. For instance, a partner cannot take advantage of the income exclusion of up to $50,000 of group term life insurance, but can participate in dependent care and educational assistance programs, including the ability to have $5,250 of principal and interest payments on qualified education loans reimbursed or paid by the employer tax free before 2026.
Employers often maintain cafeteria plan arrangements pursuant to which an employee can reduce his or her salary to fund the employer’s share of health benefit costs. This is usually the case for dependent care assistance and health benefits. However, a partner cannot participate in the employer’s cafeteria plan. Inclusion of a partner here disqualifies the entire plan, making all benefits for all plan participants taxable.
M&A Considerations
While the IRS has not issued final regulations for many of the cafeteria plan provisions and thus is reticent to enforce these rules, the statute is clear, and issues often arise in due diligence for a merger or acquisition. While parties can often reach an agreement regarding this issue, elimination of the risk because of the violation is clearly preferable. For that reason, companies should proactively review participants in their cafeteria plan to ensure that no individual holding capital or profits interest is a plan participant. If any such individuals are found to be participants, then remediation can occur by eliminating their participation and, if necessary, amending employment tax returns. Frequent review of this will enable corrections to be made in a current quarter, eliminating the need for an amended employment tax return.
With discovery of this issue during an acquisition, the parties will need to discuss the best way to correct. In most cases, the purchaser will require that the target indemnify them for the risk of tax assessments. It would also be possible to resolve this issue with an IRS closing agreement, although this is a rare approach.
Equity compensation for partnerships is an excellent way to enable individuals to share in the growth of the technology company’s current value and/or future appreciation, providing incentive for increased profits. Ultimately, the inability to participate in some pre-tax fringe benefits is a small price to pay for the benefits of ownership.