an employee must decide whether a
Section 83(b) election should be made.
If the stock vests over time based upon
certain events and restrictions, the stock is
subject to forfeiture if these events do not
occur. Because the employee recognizes
income when these restrictions lapse,
the employee will, absent a Section 83(b)
election, recognize income at such times
and in the amount of the fair market value
of the stock at the time it vests. To mitigate
against this potential increase in taxable
income, the Internal Revenue Code
permits the employee to make an election
under Section 83(b) to recognize income
immediately based upon the fair market
value of the stock on the award date rather
than on the future vest date.
Compensation
and LLC employers generally do not
grant options because options do not
work efficiently with profits interests.
Additionally, incentive stock options are
unavailable to partnerships. Therefore,
an employer must determine whether the
employee will be granted a capital interest
or a profits interest in the partnership.
A capital interest is an interest that
would give the employee a share of
the proceeds if the partnership's assets
were sold at fair market value and the
proceeds were distributed in a liquidation
of the partnership. This determination
is generally made at the time the capital
interest is awarded to the employee.
than a capital interest. Said a different
way, a profits interest entitles the holder to
a share of partnership income and future
appreciation in value of the partnership's
assets, but no share of current proceeds
if assets were sold at fair market value on
the date the interest was awarded and the
partnership was liquidated.
The grant of a capital interest is treated
as compensatory to the recipient in an
amount equal to the fair market value of
the capital interest at the time the interest
vests. If the interest vests immediately,
the recipient will recognize compensation
income immediately. If the interest vests
over time, the recipient will recognize
income as the interest vests, at the current
fair market value of the interest each time
it vests, absent a Section 83(b) election.
Assuming a capital interest is granted, fair
market value for purposes of determining
the income recognized by employee and
the deduction to which the employer
partnership is entitled becomes an issue.
In determining fair market value, two
choices are available:
interests valued using a liquidation
value approach in which the value of
the interest is the amount the recipient
would receive on the date the interest
is awarded if the partnership's assets
were sold at fair market value and
the proceeds were distributed in a
complete liquidation of the partnership.
vests immediately, or vests over time
and for which a Section 83(b) election is
made, the liquidation value safe-harbor
election would result in a zero value of
the interest for tax purposes which would
be beneficial for the recipient because
the recipient would recognize no income.
Where a profits interest subject to vesting
is awarded and no Section 83(b) election
is made, the treatment to the employee
is problematic. Unless the partnership is
revalued under the liquidation approach at
each time the interest vests, it is arguable
that the profits interest could transform
into a capital interest over time and result
in the recognition of income to employee
in future years as vesting occurs.
If a capital interest is awarded, the
safe-harbor election to use the liquidation
method should not be made so that
minority interest and lack of marketability
discounts can be used in determining
fair market value. If a profits interest is
awarded, the liquidation value safe-harbor
election should always be made, and if
the interest does not vest immediately, the
employee should always make a Section
83(b) election.
The considerations in determining
in what form to grant employee equity
incentives and the tax consequences are
complicated. Always consult counsel
and tax professionals before providing
equity incentives.