Incentive Plans of Pass-Through Entities: Tax Traps for the Unwary

Amy E. Drake
Counsel, Tax Department
John E. Rich, Jr.
Director & Chair, Tax Department
Published: New Hampshire Bar News
February 16, 2022

In order to attract, retain and incentivize key employees, owners of pass-through entities, including LLCs taxed as partnership and S corporations, frequently use equity-based compensation awards providing benefits based directly or indirectly on the appreciation in the value of the entity.  This article will describe some (but not all) of the major tax traps that attorneys should be aware of when clients ask them to draft equity-based compensation programs and awards for their employees.

Unvested Interests and Section 83(b) Elections

The recipient of a compensatory equity interest is required to include the fair market value of the equity interest (less any amount paid for such interest) in gross income under IRC Section 83(a).  However, to the extent “unvested” – meaning the interest is both non-transferable and subject to a “substantial risk of forfeiture” – then no income inclusion is required until the first taxable year in which either restriction lapses.  An example of a “substantial risk of forfeiture” is a requirement that the equity interest be forfeited if the recipient does not remain employed for a certain period of time.  If the deferral of tax is desired, counsel needs to ensure that document provisions clearly prohibit any transferability and include a substantial risk of forfeiture.

Because of the potential increase in value between the date of grant and the vesting date, it is advantageous for recipients of unvested equity interests to file an “83(b) election,” which allows the recipient to include the value of the interest in gross income in the year of grant, rather than in a later year when the value may be much greater.  83(b) elections must be timely filed with the IRS no later than 30 days after the date of grant. There is no relief for a missed or late 83(b) election.

S Corporation “One Class of Stock” Requirement

Under IRS Section 1361(b)(1)(C), an S corporation can only have one class of stock.  While S corporations are permitted to issue multiple classes of equity that confer different voting rights, in general, all shares of an S corporation must have identical rights to the corporation’s distribution and liquidation proceeds.  “Profits interests” that entitle the recipient to a share of the partnership’s future profits and appreciation (but have no current liquidation value) are an attractive option frequently used by entities taxed as partnerships as profits interests are not taxable upon receipt.  However, any attempt to issue profits interests from an S corporation will likely result in a “second class of stock” in violation of IRC Section 1361(b)(1)(C).  The result is termination of the corporation’s S election resulting in taxation as a C corporation.

Beyond the obvious issue of granting profits interests, attorneys should carefully analyze any arrangements in an S corporation’s governing documents and other binding agreements relating to distribution and liquidating proceeds that might give rise to a second class of stock.

Loss of Employee Status for Profits Interest Recipients

As noted above, “profits interests” are a popular type of equity compensation.  Employees of an entity taxed as a partnership who receive a profits interest (or any ownership interest in an entity taxed as a partnership) can no longer be treated as employees of the partnership due to their newfound “partner” status.  IRS rules prohibit a partner from being treated as an employee; rather, compensation received by profits interest holders is treated as “guaranteed payments” by the partnership, requiring the payments of quarterly estimated taxes and which are subject to 15.3% self-employment tax (SECA), essentially requiring the profits interest holder to pay the “employer half” of payroll taxes.  Perhaps more importantly, if the recipient of an unvested profits interest continues to be treated as an employee, the risk is that the profits interest may not satisfy the Safe Harbor rules set forth in IRS Revenue Procedure 2001-43, in which case the profits interest might be fully taxable upon vesting at the then fair market value.  In addition, partners are unable to participate in Section 125 cafeteria plans, with their participation causing income inclusion on benefits paid and potentially disqualifying the 125 plan entirely.

Tax Code Section 409A

The IRC Section 409A rules governing the taxation of deferred compensation must be considered in drafting any nonqualified deferred compensation arrangement irrespective of whether the benefit is calculated based on equity appreciation.  Key elements of IRC 409A compliance are payment only upon specified events such as separation from service, death, or change in control or a fixed date, and no discretion on the part of the employer or employee as to when payments are made.  The adverse tax consequences of 409A noncompliance are substantial. Current taxation is required in the year of the 409A failure on amounts deferred and for all prior years if there was no substantial risk of forfeiture and the amounts were previously untaxed.  Interest on unpaid taxes and a 20% penalty are also imposed on the employee.

Beware of ERISA

Although not a part of the Tax Code, the federal law governing employee benefit plans, the Employee Retirement Income Security Act of 1974, as amended, (“ERISA”) is potentially applicable to any equity-based plan for employees that defers payment to retirement and is taxed as ordinary income.  The substantive provisions of ERISA will not apply to a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees under the so-called “top hat plan” exemption.  As unintended coverage by ERISA can result in income inclusion under the Code and tax penalties, attorneys need to be mindful of ERISA as well when drafting equity based compensation.

In summary, before drafting plans using equity-based compensation plans to reward employees, attorneys should be aware that there are major tax traps lurking that can catch even experienced attorneys unaware.