Business Insights

Equity Based Compensation Retention and Succession Strategies

July 2016

Equity based compensation plans are commonly used by publicly traded and privately owned companies to retain key employees, and by privately held businesses as part of their overall succession strategy. These plans can be implemented regardless of whether the company is a C Corporation, S Corporation, LLC or other type of partnership. Many forms of equity based compensation exist to achieve the company’s goals. Some involve rewarding key employees with actual ownership quickly or gradually through the use of vesting provisions, while others are designed to provide a cash equivalent in wages to the amount that the company’s equity increases in value over a specified time. Triggering events may be based upon a term of years or upon the occurrence of a future event such as retirement, a sale of the company, or a public stock offering.

Many times these compensation strategies are dismissed out of concern that management or voting control would be diminished, but this doesn’t need to occur unless it is desired. The use of nonvoting common stock is not considered a second class of stock that would terminate S Corporation status as long as there are no other differences or rights between nonvoting and voting common stock. Similarly, the use of multiple classes of LLC membership or partnership units permit control to be retained in a selected group of owners and may provide that the other members or partners have limited or no control in the management of the company beyond major decisions of the partnership as desired. Other forms of equity based compensation only provide for cash compensation in an equivalent amount to what an owner would have received for appreciation subsequent to providing the award to the employee (i.e., bonuses tied to the increasing value of the company).

With the use of vesting, forfeiture and/or buy back provisions, the company can limit ownership to continuing employees as well as plan the timing of the benefits to the key employee to be immediate, gradual or through cliff vesting. With the exception of employee stock ownership plans (ESOPs) and incentive stock option plans (ISOs, or statutory options), which are both qualified plans, these plans are all nonqualified plans. Qualified plans, like 401(k) plans, must comply with very formal and defined statutory requirements designed primarily to prevent discrimination whereas nonqualified plans must satisfy only basic tax requirements. For that reason, nonqualified plans permit a greater amount of flexibility and permit the company to target benefits to key employees. Some of the nonqualified equity based compensation plans in use include the following:

1. Nonqualified Stock Options
2. Restricted Stock
3. Phantom Stock
4. Stock Appreciation Rights (SARs)
5. Junior Stock
6. Partnership Profits Interests
7. Partnership Capital Interests
8. Partnerships may also design plans comparable to Phantom Stock or SARs to mirror the results of an ownership interest in the partnership with cash compensation.

This information is only a broad overview of equity based compensation strategies and alternatives. Our tax professionals can help you with any questions you may have, as well as the design or revision of equity based compensation plans to meet your objectives. Please reach out to our tax professionals at info@richeymay.com. We are also hosting a webinar in August on this subject; look for an invitation to participate soon.