Companies often promise service providers equity, both as compensation for past services and as an incentive to remain with the company. However, it is not uncommon for this promise to fall by the wayside and go unfulfilled. As Business owners focus on running their company and growing the business, they sometimes neglect to track equity grants made under complex equity incentive plans and in conjunction with a growing capitalization table. However, the failure to make grants when promised, and the effort to attempt to fulfill that promise in later years, can cause significant problems for the company that may be difficult to remedy.
This post is the first in a series that will outline the issues that can arise when a company fails to make grants at the time promised. Part 1 discusses the practical limitations or difficulties encountered with respect to administrative tax matters when a company desires to make grants retroactively effective to the time when the original grant should have been made.
Tax Ramifications
If a company attempts to rectify the failure to grant equity in a prior year by making a current grant retroactive to the date such grant was intended to be made, then the company is required to amend the tax return from such prior year to reflect the grant.
However, if the grant is intended to be retroactive to a tax year for which an amended return may not be filed, then the company could not make the grant retroactive to such date; rather, the grant would have to be made retroactive to a year for which amended returns could still be filed or made effective in the actual year the grant is made.
Even worse, if the company is a partnership or S corporation and the company intends to make the grant retroactive to a prior tax year, then the company would need to amend not only the tax return for the year the grant is effective but also each subsequent tax year.
While the company obligation of filing amended tax returns for one or more tax years may be administratively burdensome and costly, the largest obstacle in making grants retroactively effective for companies taxed as partnerships or S corporations is that each partner, member or shareholder would likewise be required to amend their respective tax returns to take into account the variation in items reflected on the amended Schedule K-1s. If a company has numerous partners, members or shareholders, then making any grant retroactive to prior tax years would likely be impracticable or not possible.
In addition to the administrative burden on the company and existing shareholders, members or partners, the grant recipient may also miss out on making tax elections that would save the recipient taxes and force such recipient to likewise amend prior year returns. Specifically, if the company is attempting to make a grant retroactively effective to a prior tax year and that equity remains subject to vesting in the year of actual grant, then the recipient would not be eligible to make a Section 83(b) election to include the value of the entire grant in income in the year such grant is to be retroactively effective. Instead, the recipient would be required to include the value of the shares in income as they vest. By not being able to file the Section 83(b) election, the recipient would not only incur more taxes than it otherwise would if such election could be filed if the value had appreciated since the retroactive effective date but would also be required to file amended returns for each year the equity had vested.
For example, assume an LLC with five members and taxed as a partnership promised to grant 1,000 Units to a service provider in 2021, with one-fourth of the equity vested at the time of grant and the remaining three-fourths vesting equally over the next three years. If the LLC failed to make the grant in 2021 but later granted the equity in 2023 with a retroactive effective date to 2021, then the LLC would be required to amend its 2021 and 2022 tax returns, as well as the Schedule K-1s issued to the members, to reflect the addition of the service provider as a member. Moreover, each of the five members and the service provider granted the equity would be required to amend their individual tax returns for 2021 and 2022. Finally, since the grant was not made until 2023, the service provider would not be entitled to file an 83(b) election to include the full value of the 1,000 Units in income in 2021 rather than when they vest. Accordingly, if the value of the Units increased in value following the 2021 effective date, the service provider would pay more in taxes on the grant than he otherwise would have if the grant were made in 2021 when promised.
Startups and entrepreneurs are often moving quickly, and making verbal promises of equity grants without actually awarding the grants in the year they were promised is not uncommon. However, most business owners (or employees being given the grants) do not understand the long-term financial and tax ramifications of a delay.
In our next post, we’ll dive into the tax implications for equity grants if the company is worth more when the owner actually awards the equity vs. when the equity was originally promised.
