Small businesses often find that giving a stake in their company to employees, in the form of stock options, is an attractive option to improve employee retention and increase productivity. However, in doing so, these businesses often face significant tax problems that counter the business owner’s good intentions.
Commonly, when business owners choose to give a stake in the business to employees, they quickly think of stock options as the only way and often do not look further to see if other options exist. Other options do exist. One of these options is profit interest.
What is the primary difference between stock options and profit interests?
Granting stock options is a traditional type of giving equity to someone, which, when vested, falls under the umbrella of taxable income to the recipient. On the other hand, granting a profit interest in the business is a legal form of equity that limits the reach of the grantee to the company’s profits.
Profit interests are generally tax-free alternatives to stock options. The IRS has a specific safe harbor for recipients of profit interests, further increasing the value of this option for everyone involved.
How else does this benefit your business?
This alternative to the traditional stock option also protects the company because it only entitles the employee to future gains and profits and gives the employee zero rights to any previously accumulated value or capital. This is key when considering giving any stake in your business to anyone.
When thinking about how best to manage your LLC, it is critical to consider the different alternatives available for sharing part of your business with employees. While there are many benefits to giving a stake in your company, and it can certainly help it grow, there are different ways of doing this, some of which are more beneficial and cost-effective than others.