Stock/Equity Compensation, is it Really a Good Idea?

June 15, 2022

Rewarding and retaining top talent has always been a challenge for employers. The now infamous Great Resignation has brought that challenge more into the forefront than ever. For upper management and similar key employees, today’s compensation reward must be balanced by a retention framework that ideally is tied to the success of the business. This more often than not leads business owners and employees alike to discuss compensation strategies that include company stock or equity. It seems to be purely human nature, but employees really want to be able to say they are an owner, often times not really knowing what that even entails.

The most common arrangements include restricted stock awards/units, nonqualified stock options, and incentive stock options. Arrangements can take on a variety of different characteristics but they typically fall into one of these three buckets. Each bucket, of course, comes with its own set of tax rules and associated income ramifications. However, long before deciding on what arrangement to implement, ownership needs to be sure 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 have to use great care in particular when compensating with equity. S-corporation 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. C-corporations have far greater flexibility when designing equity based compensation arrangements because of their ability to have different classes of stock. LLCs 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 also provide challenges to the recipient. How are the employees going to actually get the stock, purchase or the company gives it to them? 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 new personal income tax reality that can be very 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 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 in particular 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 it does not make sense for their organization to allow it to be acquired by their employee, 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 stock/equity compensation decision can be very 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.

If you have questions, please contact Mark Flanagan of Aronson’s Compensation and Benefits Practice at 301.231.6257.