Equity & Equity-Like Plans for S-Corporations

June 16, 2023  |  By

Founder: “I want to give out equity to key employees, but I formed my business as an s-corporation. What options do I have?”

S-Corporations Generally

Starting out, it is most helpful to list what types of equity plans are not available for a company taxed as an s-corporation and why. These plans include:

  • Equity Incentive Plans (EIPs): An EIP is usually only used for c-corporations, and certain types of Restricted Stock are not allowed because s-corporations under the Internal Revenue Code may only have one class of stock with identical financial rights. A s-corporation could have an equity incentive plan that issues only stock options (described below), but these are rarer.
  • Incentive Unit Plans/Profits Interests: This type of plan is generally not allowed in an s-corporation because Incentive Units or Profits Interests have different financial rights than other stock/membership interests in the company. Specifically, the Incentive Units/Profits Interests are subject to a hurdle, and they only participate in the financial appreciation of the value of the business. Again, this violates the one class of stock rules for s-corporations under the Internal Revenue Code.
  • Restricted Stock (RSPAs) and Different Types of Stock: Similar to the other types of plans above, Restricted Stock is considered a different share “class,” again running afoul of the s-corporation one class of equity rules. Similarly, an s-corporation cannot have different classes of stock (such as preferred stock, series seed 1, etc.) due to the one class of equity rules.

With these plans out of the way, we now turn to what types of plans are available for an LLC or corporation taxed as an s-corporation:

Stock Options

Stock Options, commonly used in many c-corporations, are an option available for s-corporations as well. Stock Options are not considered a different class of stock; rather, they are simply an option to purchase the stock of the s-corporation at a later date. Advantageously, Stock Options can be subject to vesting and other restrictions on exercise, without running afoul of the restrictions on the single class of stock for s-corporations. Corporations taxed as an s-corporation may have a Stock Option only plan. LLCs taxed as s-corporations may use contractual Option Agreements, which have similar characteristics to non-qualified stock options in a corporation. If the stock options are exercised, converted to stock, and the stock is held for more than one year, a gain from the sale of the stock may qualify for capital gains treatment.

Grants of Common Stock

Many founders and individuals forget that granting or selling stock with the same voting and financial rights as the existing owners of the s-corporation is always an option. Items to keep in mind here include:

  • Grants of stock must have an established fair market value. This value must either be paid by the recipient or reported as income (salary) in the year of the grant. This will result in taxable income for the employee/service provider receiving the stock grant.
  • Restricted Stock with vesting or repurchase criteria are not allowed. See above.
  • The financial rights for the stock granted must be identical to all other shareholders. This means that if someone is a 20% owner of the s-corporation, they will report 20% of the income and losses of the company. S-corporations are not allowed to allocate income differently than the ownership of the company dictates.
  • If the Stock is held for more than one year, any gain from a sale of the shares may qualify for capital gains treatment for the participant.

Phantom Stock/Parallel Unit Plans

Phantom stock, also known as a parallel unit plan or a synthetic equity plan, is a type of equity-like bonus plan used for employees and other service providers. The plan is set up to “mimic” the value of a certain percentage or number of shares in a company, and provide for payment to the plan participants when a trigger event or events under the plan occur. Permitted trigger events include:

  • Death of Employee/Service Provider
  • Separation from Service of Employee/Service Provider
  • Change In Control of Company
  • Disability of Employee/Service Provider

The vast majority of plans include a single trigger event, usually like an acquisition or sale of the Company. A phantom stock plan provides that when a trigger event occurs (such as a change in control), the Company must value the equity of the Company and then determine the amount of the payment to the Participant.

In a Change in Control situation, this is usually pretty easy: the value of the company is the sale price, or cash sale price being paid by the third party. Payment under the Phantom Stock Plan may be all at once at closing, or spaced out as the payments are made in the change in control transaction, provided that such amounts are paid within five (5) years. Items to keep in mind with a Phantom Stock plan include:

  • The Phantom Stock is not actual equity in the Company and has no value until a trigger event occurs. This means that receiving the grant of the phantom stock should not be taxable to the employee/service provider.
  • When the Phantom Stock plan makes payments to individuals/entities, that payment is generally treated like a bonus or ordinary income in the year of payment. This means it is subject to ordinary income tax rates (not capital gains), in most cases.

Some other things to keep in mind:

S-corporations have restrictions on the types of shareholders in the business, which generally limits shareholders to U.S. citizen individuals and certain types of trusts. Most entities (such as LLCs, corporations, etc.…) are not allowed to be an s-corporation shareholder, with some limited exceptions.

Additionally, s-corporations, unlike companies taxed as a partnership, require only pro-rata allocation and distribution of income, losses, etc. This means that when one owner receives a distribution from the business, generally all owners must take a distribution (including any employee owners).

In many cases, a company taxed as an s-corporation is structured as a corporation (with stock/shares, a board of directors, and shareholders). However, s-corporations can also be structured as an LLC at the state level, with membership units/interests, managers, and members. All limitations discussed above apply to s-corporations generally, whether structured under state law as a corporation or a limited liability company.

Having an s-corporation for tax purposes can make giving employees and service provider equity more complicated. However, there are possibilities in that complexity.

Hopefully this post will help you understand the equity and equity-like options available for LLCs and corporations taxed as s-corporations, and provide a starting point for consideration of your overall compensation structure for employees, advisors, independent contractors, and other service providers.

About the Author(s)

Candace Groth

Candace Groth is a senior attorney at Vela Wood. She focuses on mergers & acquisitions and complex LLC matters.

Learn More