With the return of some prosperity in the economy, we have seen an uptick in employers granting or selling equity (stock or partnership interests) in their businesses to their employees.  In some cases, these grants are part of a broad-based employee stock purchase program.  In other cases, employers use equity to reward and incentivize key players in their business.  In all cases, these programs can be very successful in creating loyalty and incentivizing employees.  However, these arrangements are subject to a variety of regulatory requirements.  A few insights on some common issues that arise with respect to these arrangements: 

Sale of Equity to an Employee May be Compensation.  The transfer of equity to an employee (or other service provider) in connection with the performance of service to the employer is a compensatory transaction under Internal Revenue Code Section 83.  The amount of the compensation income to the employee is the difference between the fair market value of the equity at the time of grant and the amount the employee pays for the equity.  Depending on the situation, an independent valuation of the business may be necessary to establish the fair market value of the equity granted.  In all cases, the employer should document that a reasonable valuation method was followed in establishing the fair market value of the equity. 

Employees May Elect Early Taxation of Unvested Equity If an equity award requires the employee to continue to provide services after the date of grant in order for the employee to retain the right to the equity, the equity may be unvested.  Unvested equity is not taxable to the employee at the time of grant, but becomes taxable to the employee once the equity vests.  An employee who believes an equity award will increase in value and generate a larger tax hit on the vesting date rather than the grant date may elect to accelerate the taxation of the equity to the date of grant (and thus pay taxes when the equity is worth less).  This election is commonly referred to as an 83(b) election.  Employers should ensure that employees are aware of the 83(b) election option. 

Unvested Equity May Not Create Ownership.  The Internal Revenue Code provides that an employee is not treated as the owner of the equity granted to an employee unless the equity is fully vested or the employee files an 83(b) election with the IRS.  Further, employment agreements, operating agreements and shareholder agreements often contain provisions that create ambiguity as to whether an equity award is vested or unvested.  Accordingly, if the parties want to ensure that an employee receiving an equity grant is treated as an owner for tax purposes, including allocations, distributions and dividends, a protective Section 83(b) election could be filed to ensure the employee is treated as the owner of the equity.  

Equity Grants May Impact Employee Benefits.  Equity grants of partnership interests or stock in an S corporation may have a significant impact on the medical and fringe benefits of employees receiving those grants.  If the equity is vested or the employee files an 83(b) election, the employee may be treated as an owner for benefits purposes.  Partners in a partnership and owners of more than 2% of the stock of an S corporation are generally not eligible to participate on a pre-tax basis in the medical benefits and other fringe benefit programs otherwise available to employees.  In addition, employers should review their retirement plans when granting equity awards to employees to ensure that the compensatory value of the equity awards are accounted for in accordance with the terms of the plan document.  

Equity Grants Should Be Accomplished Through a Compensatory Plan.  In general, unless  securities exemptions exists at both the state and federal levels, the grant or sale of employer stock or partnership interests to employees must be registered under the Securities Act of 1933.  This rule applies to private non-publicly traded companies as well as publicly traded companies.  Many private companies may take advantage of a special federal securities exemption from the registration requirement by satisfying what is referred to as Rule 701.  However, Rule 701 and many state securities laws may only be relied upon if the grants were made pursuant to a written compensation contract or compensatory benefit plan for employees, consultants and/or directors.  Further, in some cases it may be required, but it is always a good practice, to provide the award recipients a summary of the material terms of the equity award, a risk of investment statement, and annual financial statements to minimize misunderstanding and the risk of legal claims.