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Key employees at most high-tech, biotech and other start-up companies demand equity. To satisfy this need, corporate employers frequently rely on stock options. Unfortunately, partnerships or limited liability companies taxed as partnerships don’t have as easy a decision. They can be, and arguably need to be, more creative to satisfy employees’ demands for equity participation. Assume a new client — let’s say Biotec Partnership — comes to you for advice on how to provide equity or equity-based incentives to its employees. Its founders and investors already have established their economic deal and have estimated Biotec Partnership’s fair-market value at $1 million. What are some of its best alternatives for compensating its employees with equity? While there are a number of techniques, and endless variations thereof that can be used to compensate partnership employees, there are basically three categories of equity or equity-based interests: partnership interests, partnership options and phantom partnership interests. PARTNERSHIP INTERESTS Biotec Partnership can issue to its employees a partnership interest that is either a capital interest or a profits interest. A capital interest has a liquidation value on receipt. For example, if, on the day of an employee’s receipt of a 5 percent partnership interest, Biotec Partnership were to sell all its assets for fair-market value and then liquidate, that employee — let’s say Allison — would have a capital interest because she would be entitled to $50,000 of the liquidation proceeds. On the other hand, a simple 5 percent profits interest would have no immediate liquidation value, but because it would share in 5 percent of Biotec Partnership’s distributions in excess of $1 million, it certainly should have some intrinsic value. There are several business and tax considerations with the issuance of either type of partnership interest. With capital interests, the investors or other owners may object to the immediate dilution of their equity. In fact, usually they are entitled to the first distributions from the partnership — akin to preferred stock — and want to maintain this preferential distribution right. The partnership, and particularly the employee, also may be surprised by a capital interest’s potential adverse tax results for the employee. The tax treatment of issuances of partnership interests is not entirely clear. However, the issuance of a capital interest typically is taxable to the employee, and this tax may come at a time that the employee may not have enough available cash to pay this tax. While the timing and amount of the employer’s deduction of the related compensatory element is usually tied to the employee’s timing and amount of compensation, typically start-up companies are delighted to defer these deductions due to their start-up losses. Consider the example set forth above. Allison, who draws a $60,000 annual salary, would have additional compensation equal to the fair-market value of the capital interest — presumably $50,000, although it could be otherwise — and Biotec Partnership would get a corresponding deduction upon issuance of the 5 percent capital interest. Ouch! However, Allison will be able to defer the tax on the $50,000 of ordinary income if the interest is subject to certain transfer restrictions and a “substantial risk of forfeiture” (i.e., conditioned upon her future performance of substantial services) until either of these restrictions lapse. Of course, this deferral comes at the potential cost of higher taxation for the employee. The dilemma for Allison? Defer the tax on the $50,000 but then be subject to tax at the higher ordinary income tax rates on the future value of her interest, which could be either less (in which case, she made a wise choice) or higher (in which case, she may have made a disadvantageous choice). Alternatively, upon receipt of an interest subject to both of these restrictions, Allison may make a �83(b) election to take the $50,000 into income immediately and start her holding period in the partnership interest, which may lead to the promised land of lower capital gains rates on any future appreciation of the interest if she waits a year to sell her interest. A profits interest typically avoids these issues, because the cash investors and, in effect, the IRS will view the profits interest as having little or no current value because it is a subordinated equity interest. Indeed, if the profits interest is structured properly (e.g., its value is speculative and it is not sold within two years of its issuance), Allison may avoid all or any significant taxation upon receipt of the interest, start her holding period for her interest and virtually have the same economic benefits, particularly if there is a “catch-up” provision for the “lost” $50,000 capital interest. Wow! Where does she sign her employment agreement and the partnership agreement? To structure a profits interest, the partnership agreement should provide the existing partners with a liquidation preference equal to or perhaps even in excess of the fair-market value of the partnership on the date of the issuance of the interest. Thus, in Biotec Partnership, Allison and the other key employees would share in current distributions only after the investor partners get their capital back and distributions generally exceed $1 million. In addition, if Allison’s profits interest is subject to the dual restrictions, she should make a �83(b) election to, in effect, close the compensation element of the receipt and start her holding period. While the use of partnership interests, particularly profits interests, may be desirable (and such interests have been used for years in real estate, oil and gas, venture capital and other partnerships), there are negatives, too. Among them are that the employees are immediately owners and, if the partnership has taxable income, they may have “phantom income,” taxable income without any cash distributions. However, there are strategies to minimize these negatives, such as nonvoting interests and a partnership requirement to make distributions or loans of amounts necessary to pay taxes. The possibilities are virtually limitless. PARTNERSHIP OPTIONS Biotec Partnership could issue to its employees an option to acquire either a capital interest or a profits interest in the partnership. Generally, the employee will pay a premium for the option and the option will have a stated exercise price. The tax treatment of options is not entirely clear, but it appears that if an employee receives an option that is treated as such under the tax laws, the employee will defer taxation, if any, at least until such time as the exercise of the option. In most cases, no �83(b) election can be made to take the value of the option into income upon receipt. Instead, an employee who has an option to acquire a partnership interest generally will have income, taxable at ordinary income rates, upon her exercise of the option in an amount equal to the excess of the fair-market value of the interest received over the exercise price, plus the premium paid for the option, if any. Obviously, this value will be impacted by the interest’s distribution rights as a capital or profits interest. However, under the rules outlined above, this taxation may be further deferred if the interest then received is subject to the dual restrictions. Biotec Partnership can “issue” a phantom partnership interest to an employee, which treats the employee as if she were issued an interest, typically a profits interest, in the partnership. A phantom interest can entitle an employee to a payment equal to a certain percentage of current distributions, such as a dividend equivalent right in the corporate context, and/or a certain percentage of the increase in the value of the partnership over a certain period of time, such as a stock appreciation right in the corporate context. The employee should not be taxed when the phantom interest is established, but she will be taxed at ordinary income rates on all payments she receives from the partnership. Thus, unlike a partnership interest, the employee has no possibility of capital gains treatment on its receipts from the partnership. Phantom plans can be structured in a variety of ways, and such plans are useful for situations in which the partnership does not want to admit the employee as a partner. However, phantom plans can be problematic if measures are not taken to ensure that the employee is not deemed to be an actual partner for federal income tax purposes. Even though the law in this area is not clear, in general, the phantom interest must be issued in connection with the performance of services; must not be deemed to be excessive compensation; must not convey voting rights; and must be designated as an “unfunded, unsecured promise to pay” money or property in the future. Richard M. Fijolek is a partner and Vicki L. Martin is an associate with the business planning and tax section of Haynes and Boonein Dallas.

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