An employee or potential employee should understand the tax consequences of receiving equity compensation before agreeing to a particular arrangement. Otherwise, the employee may get more than he or she bargained for when it comes time to pay taxes.

1. http://biztaxbuzz.com/compensating-employees-with-equity/ May 21, 2013
Compensating Employees with Equity | BizTaxBuzz by
Trevor Crow
25thMarchCompensating Employees with Equity
Posted by Trevor Crow
Alex has been the top salesman at Big Widgets Inc. for the past 3 years. The two founders of Big
Widgets, Barb and Cole, want to reward Alex and give him an incentive to continue working for the
company, so they decide to issue Alex shares in the company. Alex is grateful for his new
ownership interest in the company and Barb and Cole are excited about Alex’s future contributions
to the company. Everyone is happy, right?
Maybe not. Alex was happy until his accountant told him he has to pay tax on the value of the
shares he received. Alex says that can’t be right because “I haven’t realized any gain.”
Alex received stock in a company that he can’t sell (or use to pay his taxes). Yet, he has income
equal to the value of the stock. In other words, he has a tax bill but no money to pay the tax.
For tax purposes, the issuance of equity (e.g., stock or membership interests in an LLC) to an
employee is treated as if (1) the employer paid cash to the employee, and (2) the employee used
the cash to buy the equity from the company. Accordingly, the cash payment from the employer
to the employee is treated as compensation and taxed at ordinary income rates, and the employer
is entitled to a tax deduction for this amount. The general rule that an employee is taxed on
compensation applies regardless of whether the compensation is in the form of a paycheck or
equity. Many employees have the misconception that this equity award is a non-taxable gift.
Unfortunately, the tax code does not allow an employer to make gifts to employees. The IRS calls
this compensation.
Is there a way to structure this transaction for a different result? There are a few possible choices
that defer the tax owed over multiple years, such as restricted stock and stock options, but every
choice has advantages and disadvantages. The following is an explanation of a few alternatives:
Options
There are many rules surrounding the issuance of stock options that are outside the scope of this
article, but many companies issue options that meet certain requirements called incentive stock
options (or “ISOs”). Assume that the company issues 1,000 incentive stock options to Alex with
an exercise price of $1.00 each. Here, there is no income tax upon the grant of the ISO to Alex
and no tax when Alex exercises the ISO. Alex is only taxed when he sells the stock in the future on
the amount that his sales price exceeds the exercise price. The downside of this alternative is that
Alex has to pay $1,000 to exercise his option.
Restricted Stock
The company could issue shares to Alex subject to a vesting schedule over 3 years with 1/3rd of
the shares vesting each year as long as Alex remains employed by the company. Here, Alex would
pay tax on 1/3rd of the value of the shares each year as they vest. The potential problem with this
arrangement is that Alex pays tax on the value of the equity when it vests at ordinary income
rates. Thus, if the stock appreciates between the grant date and when it vests, Alex pays ordinary

2. income rates on the full value, including the appreciation.
Cash instead of Stock
A simple solution would be for the company to pay the equivalent value of the shares in cash
compensation to Alex. Alex would still pay tax on this amount, but he would have the cash to pay
the tax bill when it comes due. However, this arrangement defeats the purposes of granting equity
compensation (i.e., with cash compensation the company must use cash to pay Alex and Alex has
no ownership to incentivize him to perform and remain employed with the company).
Profits Interest (If an LLC)
When a company is an LLC instead of a corporation it may grant what is called a profits interest. A
profits interest is one that grants ownership in any increase in value of the company, but not in the
ownership of the current value of the company. A profits interest is not taxable upon grant. The
owner of a profits interest is taxed when and if the company allocates income to the member in
the future.
Bottom Line: An employee or potential employee should understand the tax consequences of
receiving equity compensation before agreeing to a particular arrangement. Otherwise, the
employee may get more than he or she bargained for when it comes time to pay taxes.