Your underlying entity ultimately limits you on the possible options to incentivizing key employees.

LLC - Single Member

• Extremely flexible and any of the below options will be workable

LLC - Current Partnership

• Flexible, but you must consider ALL current equity holders in the analysis

LLC Taxed as S Corp

• S corps are by nature NOT flexible for these purposes. 
  •  Workaround are possible (see profit interest section)

C Corporation

• Flexible for employee ownership or employee incentives.  However, Corps are rigid and formalities must be followed.
  • Most C Corps already have a Stock Option Plan in place.  For that reason, we are not focusing on this for this guide.

Scenario - you have a key team member with longevity that you'd like to incentivize with a form of equity.  If you "give" them straight equity, this is taxable.  The alternative is they buy the equity, which is expensive.

This is the happy medium.  

Here are the Key Details for the Profits Interest Method:

1. Grant: An employee, typically a key employee or executive, is granted a profits interest in the partnership.  This is done via a legal transfer of units.
2. Value Appreciation: The profits interest only has value to the extent that the partnership grows in value from the date of grant. If there's no appreciation, the profits interest remains worthless.
   1. In other words, if you sell the business on DAY 2, the EE would not receive anything of value.
3. Vesting: Like other forms of equity compensation, profits interests can be subject to vesting schedules, ensuring that the recipient remains committed to the partnership over a specified period.  This is normally a 4 year vesting period. 
4. Liquidity Event: When the partnership experiences a liquidity event (like a sale or merger), or when distributions are made from the partnership, the profits interest holder is entitled to a share of the proceeds, but only the amount that represents growth since the time the interest was granted.
   
   

Tax Implications:

1. Grant: Generally, the issuance of a profits interest is not a taxable event for the recipient or the partnership.  The employees DOES become a "K1" tax partner at this time.
2. Vesting: Vesting of a profits interest is also typically not a taxable event.
3. Sale or Distribution: When a profits interest holder receives a distribution or realizes value from a sale, they generally recognize capital gain income, assuming they have held the interest for more than one year. This can be advantageous compared to ordinary income rates.
   
   

**S Corp Only** - S Corps cannot issue profits interest given the Single Class of Stock rule.  However, if this is the desired scenario, we would recommend dropping operations into a wholly owned LLC.  Then, you can issue profits interest in the subsidiary LLC.  You would still own the S Corp as the owner but the operations would be under the subsidiary LLC.  This is not a straightforward move and has a lot of complexities but the option is available.  

There are some scenarios where it makes sense to give the key team member a full slice of the pie. This means that they share in the FULL equity rights the day they receive the grant.  There are generally 3 methods to accomplish this.

1) Grant of Equity in Exchange for their "Services" - this is a taxable event to the employee.  The tax is based on the fair market value of the equity.  Thus - they could face a pretty large tax bill, without the cash to pay it.  If this was the scenario, we'd generally help you create a loan to the employee to help them pay the tax bill.

2) Grant of Equity in Exchange for Cash - this is straight forward.  You have a 3rd party Certified Valuation Analyst value your company.  The employees pays for the equity.

We would recommend structuring a "seller's note" with the minimum AFR interest in order to help ease the burden of cash demands.  For example, if the purchase price was $100,000, you could withhold the first $100k of distributions with interest OR lend them the cash and they'd repay with interest.

3) Gift of Equity - this is more complex and we rarely advise this, unless the person is a family member.  Similar to above, you would get the company valued.  From here, you can GIFT the desired equity.  There is no tax to you or the recipient but if the amount surpasses the annual gift tax threshold you would need to report this and it would be removed from your lifetime exemption.

What is Phantom Equity?
Phantom equity is a contractual agreement between a company and an employee that provides the financial benefits of stock ownership without actually giving the employee any company stock. It's a promise to pay a bonus in the form of cash or equity based on the value of a set number of shares, after a predetermined period of time or upon a certain event like a sale of the company.

How Does Phantom Equity Work?

1. Grant: An employee is given phantom shares or units that represent a value equivalent to actual shares or a percentage of the company's value.
   1. We would recommend this is actually a Plan created by legal counsel
2. Value Appreciation: The value of phantom equity tracks the value of the company's actual stock. If the company's stock or valuation increases, so does the value of the phantom equity.
   1. Very similar to the Profits Interest method but the key difference is this is not real "capital gain" equity. 
3. Vesting: Phantom equity can have vesting schedules, ensuring the recipient remains with the company for a specified period to fully benefit.
4. Payment Event: Phantom equity becomes valuable upon specific events, typically:
   • A sale or merger of the company.
   • An IPO.
   • The employee reaching retirement.
   • Certain profit milestones (or revenue)
   • Specific dates or milestones.
5. Settlement: Once vested and a triggering event occurs, the company typically pays the value of the phantom equity in cash.  

Tax Implications:

1. Grant: Generally, there are no immediate tax implications for the company or the employee at the time of the grant.
2. Vesting: Vesting in itself doesn’t usually trigger taxation.
3. Payment: When the phantom equity is settled (paid out), it's treated as ordinary income for the employee. The company can typically take a corresponding tax deduction.
   1. This is straight W2 income to the EE

Benefits of Using Phantom Equity for Incentivization:

1. Alignment of Interests: Aligns the interests of key employees with company growth without diluting ownership.
2. Flexibility: Agreements can be tailored to specific conditions, timelines, or performance metrics.
3. Simplicity: Avoids the complexities of actual stock issuance, securities laws, and stockholder rights.
4. Cash Preservation: No cash outlay is required until a triggering event occurs.

Wrapping Up:

We explored three different ways to incentive your key team members.  When you are thinking about this, use the Anomaly Equity Roadmap:

1) What is your entity type?  Remember, S Corps are very rigid here.

2) Do you want to give them a piece of the current pie?  Or just the future pie?

3) Do you want the team member coming out of pocket?  Does the company have enough cash to loan to the employee?

As always, if you are interested in pursuing any of these options, please reach out to your Project Manager on Soraban to set up a time to discuss!