Introduction
Employees frequently receive compensation in forms other than salary, commissions, or bonuses. Employers may instead offer equity in the company at which the employee works. This is common for startup ventures that lack sufficient liquidity to fully compensate employees in cash but look to attract and retain employees by offering them an opportunity to share in the company’s growth. Providing some form of equity to employees is common both for corporations, which issue shares of stock, and limited liability companies, which grant membership interests.
Equity-based compensation can also serve as a form of golden handcuffs. An employee’s compensation agreement may provide that all or a portion of the equity-based compensation is forfeited if the employee terminates their employment before the equity fully vests.
There are both business- and tax-related considerations that must be addressed in structuring a compensation package that includes noncash employee benefits. Compensation can be offered in the form of stock, stock options, or phantom equity, such as restricted stock units. Issuing stock provides an employee with shareholder rights, including the right to vote the shares and the right to attend shareholder meetings. Those are rights the employer may not wish to extend. Shareholders are also entitled to receive dividends, which employers may not want to share with employees.
If a corporation is taxed as an S corporation or if an LLC is taxed as a partnership, the company’s taxable income generally flows through to its owners. The company may be obligated to make distributions to employees who hold equity interests to cover their respective tax liabilities on the allocated income.
Equity Compensation Alternatives
There are other forms of compensation that a corporation can offer its employees to share in the company’s growth. It can offer employees stock options with an exercise price set either at the fair market value on the grant date or at a lower amount. An employee who is granted stock options does not have the rights of a shareholder until the option is exercised.
Alternatively, employees can be offered phantom equity, which allows them to take part in the increased market value of the company’s stock without receiving actual shares. The grant of phantom equity does not entitle employees to the rights associated with ownership of the shares themselves. All the income recognized by the employee under this type of plan will be treated as compensation taxable as ordinary income. If this route is chosen, the phantom equity plan should be carefully structured to comply with the deferred compensation rules under section 409A.[1]
Vesting and Section 83
If an employee is offered company stock outright, the terms of the grant will govern when the shares vest. Shares can vest immediately, or they may vest upon the occurrence of specified events, such as completion of a required service period, termination of employment, an initial public offering, or a corporate acquisition (a liquidity event).
When equity vests will determine both the timing of when any gain is recognized and its character when the equity is later transferred or sold. An employee is treated as having received compensation taxable as ordinary income when the property is no longer subject to a substantial risk of forfeiture to the extent that its FMV exceeds any amount the employee paid to acquire it. Section 83(a) provides that an employee must treat the receipt of property in connection with the performance of services as additional taxable compensation when restrictions on transfer and forfeiture lapse, or when the property becomes transferable, whichever occurs first.[2] Section 83 applies to both the receipt of shares of stock and also to partnership capital interests.[3] Unless an employer provides a gross-up or redeems a portion of the shares to fund the liability, the employee generally must satisfy the resulting tax obligation personally.
Timing Preferences and Holding Periods
It is generally preferable from the standpoint of an employee that the section 83 restrictions lapse as early as possible. That is because the lower the value of the shares when the restrictions lapse, the less will be treated as taxable compensation when the restrictions are satisfied. This remains true even when the employee initially purchases the shares at FMV in connection with employment.[4]
When shares of stock satisfy the conditions of section 83 also determines how they are taxed upon disposition. An employee’s initial basis in the shares will be their FMV when the employee is required to include the shares in income, and the holding period will commence at that time. The employee may qualify for favorable long term capital gain treatment on any subsequent appreciation if the shares are held by the employee for more than one year before they are sold. Conversely, if the shares vest shortly before a liquidity event, any gain realized on the stock sale will be taxed as a short-term capital gain.
Employers and employees may disagree about when shares should become unrestricted. Employers generally prefer vesting and transfer restrictions to remain in effect until a liquidity event occurs, while employees usually want to recognize income as soon as possible for tax purposes.
Section 83(b) Election and QSBS
Under section 83(b), an employee may elect to include the value of shares in income at the time of receipt, even though vesting and transfer restrictions have not yet lapsed.[5] The amount included in gross income is the FMV of the shares in the year of receipt, not taking into account the vesting and transfer restrictions, less any consideration paid by the employee. This election can reduce the amount of ordinary income recognized if the shares increase in value before the restrictions lapse. It also allows the one-year holding period for long-term capital gain treatment to begin earlier.
In the context of a C corporation, an employee may wish to accelerate vesting and transferability if the equity meets the requirements of qualified small business stock (QSBS) under section 1202.[6] This is because gain recognized on a subsequent disposition may be eligible for partial or complete exclusion once the applicable holding period has been satisfied — generally at least three years for stock acquired after July 4, 2025, and five years for stock acquired before that date.[7]
What if the equity received decreases in value after it is included in compensation? If section 83(a) applies to the equity, the employee may claim either long-term or short-term capital loss treatment when the equity becomes worthless or is forfeited, depending on the holding period.[8] However, if the employee does not have sufficient capital gains to offset the capital loss, then only $3,000 of the net capital loss can be deducted in any single tax year, with the unused portion of the loss carried forward indefinitely until fully used.[9] By contrast, if the employee makes a section 83(b) election to recognize income at grant, no deduction is permitted if the property is later forfeited.[10]
Feige
Feige is a recent Tax Court case in which a retiring employee received publicly traded stock as part of a termination package.[11] The shares were worth $75,000 when Corri Feige received them in December 2014, but by March of the following year, they had lost nearly half their value. Shortly thereafter, the company’s stock was delisted from the stock exchange and became worthless. Although Feige had to recognize ordinary income equal to the stock’s FMV upon receipt, she was only entitled to a capital loss when the stock ultimately became worthless.
Feige put forth a creative argument to avoid recognizing income on receipt of the stock. She claimed that she was not entitled to the stock under her termination package and that her employer had mistakenly granted it. Feige further asserted that she attempted to return the shares but received no response from the company.
The Tax Court found that despite Feige’s claim that she wasn’t entitled to the stock, the shares were not subject to any substantial risks of forfeiture, and she retained the right to sell the stock upon receipt. Feige had full ownership and control over the stock, and there were no impediments to her disposing of the shares. Because she had the unrestricted right to sell the stock, the court concluded that the shares were properly includable in income at the time of receipt.
Partnership Profits Interests
With proper tax planning, an employee can achieve the best of all possible worlds. When a business entity is taxed as a partnership, the company can grant the employee a profits interest instead of a traditional partnership or membership interest. A profits interest is similar to a traditional partnership interest except that when a liquidity event occurs, the proceeds from the sale of the partnership interest are shared by the employer and the employee. The employer is entitled to payment equal to the FMV of the partnership interest as of the date it is issued. The employee is entitled to receive the balance of the purchase price for the partnership interest exceeding the amount received by the employer. The amount received by the employee represents the future appreciation over its FMV as of the date of the grant.
If the understanding is that the employee should receive the full value of a partnership interest rather than only future appreciation, then the employer and employee can enter into a separate compensation agreement under which the employee becomes entitled to receive additional compensation upon the occurrence of a liquidity event. The employee recognizes that amount as ordinary income upon receipt.
It has long been settled that employees do not recognize income upon the initial grant of a profits interest, even if the interest is fully vested upon issuance. The rationale is that a profits interest ordinarily has only speculative or no determinable value at the time of grant.[12] In Rev. Proc. 93-27, 1993-2 C.B. 343, the IRS said that it will respect the nonrecognition treatment for a profits interest if three conditions are satisfied:
- the profits interest cannot relate to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease;
- the partner cannot dispose of the profits interest within two years of receipt; and
- the profits interest cannot be a limited partnership interest in a publicly traded partnership as defined in section 7704(b).[13]
Additional Guidance: Rev. Proc. 2001-43
Even if the profits interest is subject to vesting restrictions or is nontransferable at the time of grant, the IRS has said that an employee is not required to recognize income when those restrictions later lapse.[14]
The tax benefits of creating a profits interest include the following:
- The employee does not recognize any income when the profits interest is initially created.
- The employee’s holding period commences when the profits interest is granted. The employee can recognize long-term capital gains on the profits interest when there is a liquidity event if the profits interest is held for more than one year.
- The employee does not get whipsawed if the value of the company’s stock decreases after the profits interest is created. No gain is recognized when the profits interest is created, nor is any loss incurred if the partnership interest later decreases in value.
This favorable treatment raises the question of how a corporate employee might obtain comparable tax benefits to an employee in a partnership who receives a profits interest. One alternative is for the corporation to issue the employee a separate class of stock designed to mirror the economic features of a partnership profits interest. However, there are potential issues with this approach:
- The corporation has to amend its certificate of incorporation to authorize additional classes of stock.
- A separate class of stock must be created each time an employee is issued a profits interest to reflect the liquidation value of the shares when issued to the employee.
- This plan cannot be adopted by an S corporation because it cannot issue a second class of stock.
- The IRS has never issued a ruling saying that a second class of stock will be entitled to the same tax treatment as a partnership profits interest.
The Single-Purpose Partnership
Alternatively, an employer and employee can form a single-purpose partnership, in which the employer contributes the shares of its stock to a newly formed partnership. The employee is granted a profits interest in the newly formed partnership in consideration for services rendered on behalf of the corporation. When a liquidity event occurs, an amount equal to the FMV of the stock on the date when the shares were first contributed to the partnership is returned to the corporation. The proceeds received by the corporation should be nontaxable based on section 1032, which provides that no gain or loss is recognized by a corporation on the sale of its own stock.[15] Any remaining partnership proceeds are distributable to the employee.
This structure can provide many of the same tax benefits as a traditional profits interest granted by a partnership. In particular, if a C corporation contributes its shares to the partnership, the shares retain their status as QSBS. Section 1202(g)(4)(A) provides that the definition of QSBS includes shares held through a “pass thru entity,” including partnerships.[16] The single purpose partnership also allows the employee to begin the QSBS holding period even though the partnership can impose vesting and transfer restrictions on the profits interest. Further, the employer may impose the same vesting and transfer limitations that typically apply to stock-based awards while avoiding many of the adverse tax issues associated with restricted stock or stock options. The single-purpose partnership cannot be used for shares of S corporation stock because partnerships are not eligible shareholders under section 1361(b).[17]
While this arrangement can be structured to provide many of the tax benefits of a true profits interest grant, the IRS has yet to issue any formal guidance on whether it will respect the intended tax treatment. The IRS could disregard the partnership and treat this economic arrangement as a nonrecourse loan made by the corporation to the employee to purchase the shares. If the transaction were treated as a loan, the employee could be subject to imputed interest when the liquidity event occurs. This would result in a portion of the gain recognized on the disposition of the stock to be treated as ordinary income rather than as a capital gain. Conversely, the IRS could argue that the employee is required to recognize cancellation of indebtedness income if the stock decreases in value. To support the argument that the arrangement is a bona fide partnership, the partnership agreement can provide that a small amount of the gain on sale is allocated to the corporation to show that there is a sharing of profits between the parties.
Practitioners seeking to implement this partnership arrangement to hold corporate stock should consider filing an election under section 83(b) even though the IRS has said that this election is not required when a nonvested traditional profits interest is issued.[18]
Conclusion
Equity-based compensation remains one of the most effective ways to align employee incentives with long-term enterprise growth, but its tax treatment under current law requires careful navigation. When employees are granted outright dispositions of corporate stock, stock options, or partnership interests, sections 83 and 83(b) dictate the timing and character of income inclusion and loss treatment if the equity value decreases.[19] Rev. Proc. 93-27 and Rev. Proc. 2001-43 provide critical (but limited) guidance for employees who are granted partnership profits interests. For corporate employers, efforts to replicate the tax benefits of a profits interest through special stock classes introduce both planning opportunities and interpretive uncertainty.
The single-purpose partnership represents a potential alternative to the granting of restricted stock, stock options, and phantom equity — one that seeks to emulate the favorable tax treatment of partnership profits interests within the context of a corporate structure. By contributing corporate stock to a newly formed partnership and granting employees a profits interest, a corporation can, in theory, extend the potential tax benefits of stock ownership to key employees (including the potential QSBS benefits under section 1202), while preserving the corporation’s nonrecognition treatment under section 1032.
[1] See section 409A.
[2] Section 83(a).
[3] See Campbell v. Commissioner, T.C. Memo. 1990-162, aff’d in part, rev’d
in part, 943 F.2d 815 (8th Cir. 1991).
[4] See Alves v. Commissioner, 734 F.2d 478 (9th Cir. 1984).
[5] Section 83(b).
[6] Section 1202.
[7] The three-year holding period reflects the amendment to section
1202 enacted by the One Big Beautiful Bill Act (P.L. 119-21), which
reduced the required holding period for newly issued QSBS acquired
after July 4, 2025.
[8] See sections 1211(b), 1212(b).
[9] Id.
[10] Section 83(b)(1).
[11] Feige v. Commissioner, T.C. Memo. 2025-88.
[12] Diamond v. Commissioner, 56 T.C. 530 (1971), aff’d, 492 F.2d 286 (7th
Cir. 1974); Campbell v. Commissioner, T.C. Memo. 1990-162.
[13] Section 7704(b).
[14] Rev. Proc. 2001-43, 2001-2 C.B. 191.
[15] Section 1032.
[16] Section 1202(g)(4)(A).
[17] Section 1361(b).
[18] Rev. Proc. 2001-43.
[19] See section 83, 83(b).