Equity compensation rewards employees with payments tied to company value, which can make it an effective tool for incentivizing performance. Understanding the variety of equity compensation options available and the circumstances in which companies use them will help you make informed decisions regarding your compensation options. The following covers both corporate and partnership alternatives available.
Inside the guide:
What is equity compensation?
Equity compensation is any of a variety of plans that tie a portion of certain employees’ overall compensation to the value of the company. In most cases, equity compensation is provided only to a business’s key employees. By aligning compensation to the value of the company’s equity, these plans may provide additional motivation to executives to increase the value of the business.
The transfer of equity generally does not create a taxable event for the existing owners because equity is provided to key employees via an incentive plan rather than transferred to them via a sale. While many equity compensation plans dilute existing ownership in the company, some programs reward participants based on equity performance without the transfer of any direct ownership interest.
When is equity compensation used?
Equity compensation may be used at different times in a business’s lifecycle or in different stages of its maturity. Startups commonly use equity compensation to attract talented employees before the business has enough cash to offer competitive salaries. For example, early-stage technology companies often provide stock options to all early employees to entice them to work for the company and to bolster their cash pay.
Other early-stage companies may have sufficient cash to offer competitive pay without providing equity compensation. In these situations, companies may choose to wait until the business is more established and equity-linked payments carry a more predictable value. Mature companies may want to incentivize management by aligning a portion of their compensation directly with company performance.
Other companies may find adequate ways to incentivize employees without introducing equity compensation until the founders begin to plan an exit from the business. At this stage, equity compensation can be a valuable way to align successors’ interests with those of the company. Since those employees may not have been involved in the business from the beginning, equity compensation may be a way to instill the founders’ commitment to the company in the next generation of leaders.
What types of equity compensation are available?
Match incentives to employer goals
Phantom
stock
Stock appreciation
rights
Company
stock
RSUs and
PSUs
Incentive stock
options
Nonqualified
stock options
Also consider:
| Tax implications |
| Compliance requirements |
| Potential impact on employee engagement |
Phantom stock
Phantom stock is one tool used to align compensation to company performance without transferring actual ownership to the employees. Phantom stock generally does not have voting or dividend rights, but the payment received by the employee is based on the company’s equity value.
A typical phantom stock plan, for example, may provide that a certain executive receives a payment in three years equal to the value of 100 shares of the company’s stock on that future date. The better the company performance and the higher the stock value on that date, the more money the executive receives.
Although phantom stock uses stock value to determine the amount of the payment, the employee receives a cash payment that is taxed as ordinary income when received, and the employer reports a deduction in the same amount, with the timing of the deduction dependent upon when payment occurs.
Stock appreciation rights
In contrast to phantom stock, which is tied to the full value of company shares, a stock appreciation right (SAR) provides a future payment based on the stock’s increase in value over a base amount.
For example, a SAR may offer the employee in three years a payment equal to the number of SARs the employee holds multiplied by the difference between the stock price upon issuance of the SAR and the stock price on the date three years from issuance.
Because SARs provide less value per share than full-value phantom stock, companies typically provide three to four times the number of SARs than shares of phantom stock. For this reason, SARs provide greater upside leverage than phantom stock. However, unlike phantom stock, SARs provide no value to the employee if the value of the stock declines.
As with phantom stock, the employee receives a cash payment that is taxed as ordinary income when received, and the employer reports a deduction in the same amount, with the timing of the deduction dependent upon when payment occurs.
An example may help you visualize how these plans work. Imagine a company president starts employment on July 1, Year 1, when the corporation’s stock value is $100 per share. As part of his employment agreement, he receives a phantom stock grant that will pay him an amount equivalent to the value of 500 shares on July 1, Year 4. If the stock price stays steady, he will receive $50,000 in Year 4.
If the stock price declines, he will receive something less than $50,000. On the other hand, if the stock appreciates 50% to $150 per share, he will receive $75,000.
Now, assume that instead of a phantom stock grant, the president on July 1, Year 1, receives 2,000 SARs at the base price of $100 that will be paid to him on July 1, Year 4. If the stock price on July 1, Year 4, is less than or equal to $100, he will receive no payment from the SARs. However, if the stock price is $150, he will receive 2,000 shares times the $50 increase, or $100,000.
Thus, the SARs are more motivating to the president because they offer greater upside if the company stock performs very well and offer nothing if the stock value declines.
Company stock
Part of an executive’s compensation package may include payment in company stock that is vested upon transfer to the executive. Payment in company stock may be valuable, as it makes the executive a direct owner with voting and other ownership rights, depending on the class of stock transferred. This not only aligns the employee’s interests with those of shareholders, but also does so without a current cash cost to the company (other than income and payroll taxes that need to be withheld and remitted to the IRS).
In the year of transfer, the employee reports ordinary income equal to the value of the stock received over the amount the employee pays for the stock. The company deducts the same amount according to its normal method of accounting for tax purposes (cash or accrual).
Restricted stock, restricted stock units (RSUs) and performance stock units (PSUs)
When employees are paid restricted stock, they are given actual company shares with some restrictions placed on them, just as the name implies. The restrictions must generally be related to the performance of future services. For example, the stock may be granted to the employee in Year 1 but not vest until Year 4. Thus, the employee must still be employed by the company three years later to possess a vested right in the shares.
Because of the conditions associated with restricted stock, employees have a risk of forfeiture until the conditions are satisfied. As long as such risk is considered substantial under the tax rules governing stock compensation, the employee will not be taxed until the conditions are satisfied and the employee is vested in the stock. Upon vesting, the value of the restricted stock is taxed as ordinary income to the employee on that date, and the employer receives a corresponding deduction in its tax year in which the employee recognizes the income.
A special tax rule allows employees to elect to include the value of unvested stock that has been transferred to them in their taxable income upon grant, rather than in the future when it vests. If the election is made, the employer also gets the deduction in that year of grant. The benefit of the election is that the employee reports less ordinary income in the event the stock appreciates during the vesting period.
When deciding whether to make the election, the employee needs to weigh a number of factors, including the risk of forfeiture, the likelihood of the stock appreciating during the vesting period, and current and future tax rates. The tax election (referred to as an 83(b) election based on the governing tax code section) must be filed with the IRS within 30 days from the date of receipt of the restricted stock.
One variation of restricted stock is a restricted stock unit (RSU), which does not actually transfer stock to the employee until after the associated vesting conditions have been satisfied. Therefore, the employee is still incentivized, but with the promise of a stock transfer in the future instead of currently. Typically, an RSU has time-based vesting conditions, whereas a unit with performance-based vesting conditions is referred to as a performance stock unit (PSU). With an RSU, the 83(b) election is not available to the employee. Instead, the employee’s recognition of income and the employer’s income tax deduction occur in the future, when the conditions are satisfied and the stock is transferred.
Incentive stock options
A stock option grants an employee an option to purchase a specified number of employer shares at a specified strike price within a given time frame. Therefore, the employee benefits if the company’s stock price rises over the strike price because they can buy at the lower strike price and sell at the higher price. When an employee exercises a stock option, the employee becomes the legal owner of the stock on that date.
Incentive stock options must meet a number of requirements in the tax code in order to qualify as incentive stock options.
The requirements include restrictions on who can receive the options, when the options can be exercised and the price at which the options must be exercised.
If the requirements are met, the employer receives no tax deduction, and the employee is not taxed upon grant or exercise. Instead, the employee is taxed when the stock is sold. Any gain on the sale is treated as capital gains income provided the stock is held for at least two years from the date of grant and one year from the date of exercise.
If the stock is sold sooner, the gain is treated as ordinary income. It should be noted, though, that the difference between the exercise price and the fair market value of the stock at the time of exercise (i.e., the value spread) is an adjustment for alternative minimum tax (AMT) purposes, which could subject the employee to the AMT even though exercise is not taxable for regular tax purposes.
Nonqualified stock options
Any stock option that does not qualify as an incentive stock option is treated as a nonqualified stock option. The tax consequence is that the employee is generally taxed upon exercise of the option on the difference between the strike price and the fair market value on that date. The gain is treated as ordinary income. When the employee recognizes income upon exercise, the employer receives a corresponding compensation deduction. This result assumes the option does not have a readily available fair market value. If the option has a readily available fair market value, which is rare, the employee is taxed upon grant rather than upon exercise.
For comparison sake: There are advantages and disadvantages to both incentive stock options and nonqualified stock options. Incentive stock options are more restrictive but can be more tax beneficial to employees.
Nonqualified options provide much more flexibility and are generally more tax favorable to the employer.
Understanding the variety of equity compensation options available—and when to use them—empowers better decisions for your business and your people.
Anne Bushman, Partner, RSM US LLP
What about partnerships, which do not have stock?
Partnerships can mimic compensation methods that do not provide actual ownership. For example, a partnership can have a plan similar to a SAR plan that references partnership equity value rather than stock price. The payments are ultimately made in cash, not equity, so the plans for partnerships use different terms but otherwise work in virtually the same manner as a similar corporate plan.
The reporting may be slightly different because partners are not employees. Thus, to the extent an executive receiving rights under such a plan is a partner, their payment may be treated as a guaranteed payment rather than wages. For payments that provide actual equity rather than cash tied to equity value, a partnership can use profits or capital interests.
Profits interests and capital interests
A profits interest provides the holder the right to share in the future profits of the business. To compete for talent with corporations that can give management stock options, many partnerships use profits interests as a form of equity compensation for key executives. If certain facts are present, a safe harbor allows a profits interest to be treated as having zero value on the date of grant, which means that the partner does not pay any tax upon the receipt of the interest and the partnership does not receive a deduction. Under current laws, the sale of a profits interest will normally result in capital gain or loss treatment, with some exceptions.
A capital interest differs from a profits interest in that a capital interest shares in the rights to the partnership’s assets on the date of grant, rather than only future appreciation. Unlike a profits interest, a capital interest has current value. Thus, it is a taxable event to the person receiving it if the value of the capital interest exceeds what they paid for it. Under current laws, the sale of a capital interest will normally result in capital gain or loss treatment, with some exceptions.
Considerations when implementing an equity compensation plan
The optimal equity compensation plan depends on the employer’s goals. The type of plan may be dictated in part by which employees must be covered (including special considerations if any employees live or work in locations outside the United States). In addition, different types of plans may lead to greater employee incentive to grow the business. An employer may have multiple equity compensation plans at the same time, and possibly separate plans for different levels of key employees.
Equity compensation may also be an important tool in planning for successor management during ownership transitions.
Because many closely held business owners are also in high-level management positions at their businesses, it can be critical to find competent leaders to succeed current owners when they want to reduce their time commitment to the business. Equity compensation can be a powerful tool in incentivizing key executives to continue their employment at the company and to make decisions that propel the company’s success.
Employers need to be aware of section 409A, which provides rules on the deferral of compensation, and its application to equity compensation plans. The regulations under section 409A generally provide exceptions for certain equity compensation arrangements, including stock options and SARs. However, the exceptions need to be carefully considered at the time the plans are drafted to ensure all the requirements are met and no unintended tax consequences occur.
One requirement in the section 409A exceptions for equity involves comparing the exercise price of options and SARs to the stock’s fair market value (FMV) on the grant date. If equity compensation is issued at FMV on the grant date, there likely is no deferred compensation because the employee must pay an amount equal to the value and receives no deferred benefits. In a closely held business, this reference to fair market value requires careful consideration.
According to section 409A regulations, stock that is not traded on a readily established securities market must have value determined based on the reasonable application of a reasonable valuation method. While multiple valuation methods could meet this requirement, an independent, professional, third-party appraisal completed no more than 12 months before the compensation is awarded is presumed to be reasonable in most cases. This valuation requirement and other section 409A rules need to be considered concurrently when offering equity compensation in closely held businesses.
The rules should not prevent implementation of certain plans, but the consequences of failure to comply are immediate taxation of the participants as the compensation vests, as well as significant penalties imposed primarily on the participant. Penalties to the employer can result as well, and employers need to ensure plans are designed and operated in compliance with section 409A.
Conclusion: Equity compensation as an effective incentive
Equity compensation isn’t just a tool for attracting and retaining talent—it’s a strategic lever that can drive company performance and align leadership interests with long-term business goals. Whether you’re leading a startup, managing a mature enterprise or planning for succession, the right equity compensation plan can help you motivate key employees and foster a culture of ownership.
As you consider implementing or updating your equity compensation strategy, focus on your organization’s unique objectives and the needs of your workforce. Evaluate each plan’s tax implications, compliance requirements and potential impact on employee engagement. Collaborate with your human resources, finance and legal teams to ensure your plan is both competitive and compliant.
RSM contributors
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