Stock and Equity Compensation, is it Really a Good Idea?
May 16, 2023
At a glance
- The main takeaway: Compensation benefits tied to the success of the business are growing in popularity, however, employers need to think long and hard about what they are giving up and the associated benefits and risks.
- Impact on your business: Stock and/or equity compensation decisions can be complex, especially if a key employee is insistent on receiving actual stock.
- Next steps: Aprio’s Tax advisors can help you navigate stock and equity compensation benefits to determine the right fit for your company.
Schedule a consultation with an Aprio Tax advisor Today.
The full story:
Rewarding and retaining top talent has always been a challenge for employers. The now infamous Great Resignation has brought that challenge to the forefront more than ever. For upper management and similar key employees, today’s compensation reward must be balanced by a retention framework that is ideally tied to the success of the business. Often, this leads business owners and employees to discuss compensation strategies that include company stock or equity. It seems to be purely human nature, but employees want to be able to say they are an owner, but they may not really understand what that entails.
So, what stock or equity options are available?
Compensation arrangements can take on a variety of different characteristics, but they typically fall into one of these three buckets:
- Restricted stock awards/units
- Nonqualified stock options
- Incentive stock options
Each of course has their own set of tax rules and associated income ramifications. However, long before deciding on what compensation arrangement to implement, owners need to be sure that giving up some of “their” ownership makes sense. These decisions are greatly impacted by the type of entity involved — C-corporation, S-corporation, or limited liability company (LLC).
S-corporations must use great care when compensating with equity because their stock must confer identical rights of distribution and liquidation proceeds. While conceptually it may not seem like an issue, we have seen situations where minority shareholders hold up the sale of the company preventing longtime shareholders from their big payday. On the other hand, C-corporations have far greater flexibility when designing equity-based compensation arrangements because of their ability to have different classes of stock. Then you have LLCs who face their own issues because their ownership structure is not based on true stock. LLC equity compensation arrangements are usually structured using “units” or “interests” with the operating agreement dictating the parameters of each.
Stock ownership can provide challenges to the recipient
An important question that must be considered is, how do employees actually get the stock? Companies can structure various arrangements to make the acquisition of stock more economically palatable, but the arrangements can come with complexities and the employees still must be able to manage the associated financial requirements.
New stockholders are faced with a personal income tax reality that can be incredibly challenging, especially for first timers. Gone are the days when their tax return was fairly simple and their pay-by-pay income tax withholdings satisfied their annual tax deposit requirements. Concepts like capital gains vs. ordinary income, K-1s, quarterly tax deposits and 83(b) elections now rule the day. We have repeatedly seen K-1s and quarterly tax deposits cause problems for first time S-corporation shareholders and LLC members. Each individual’s situation will ultimately be dictated by the structure of the compensation arrangement.
If employers believe in the value of stock as a reward and retention tool but decide allowing it to be acquired by their employee does not make sense for their organization, all is not lost. Synthetic equity allows employers to compensate employees in lieu of true equity by allowing employees to benefit from the increase in the value of company stock with their efforts directly impacting the value. Synthetic equity generally comes in two forms — stock appreciation rights (SARs) and phantom stock. These arrangements will be discussed in greater detail in a future post.
The bottom line
Stock and/or equity compensation decisions can be incredibly challenging, especially if a key employee is insistent on receiving actual stock. Employers need to think long and hard about what they are giving up and the associated benefit. Aprio’s Tax advisors can help you navigate stock and equity compensation benefits and determine the right fit for your company. Schedule a complimentary consultation to get started.
Related Resources/Assets/Aprio.com articles/pages
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About Aprio’s Retirement Plan Services
About Aprio’s Employee Benefit Plan Audits
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About the Author
Mark Flanagan has more than 30 years serving for profit and nonprofit organizations of all sizes and industry types. His specialties include retirement arrangement consulting, compensation and benefits tax compliance, and benefit plan audit technical support. His expertise and guidance allow employers and individuals to defer taxable income from the highest corporate and individual rates to lower rates sometime in the future.