Many of our clients struggle with the question of how to compensate and appropriately incentivize key employees. One solution relied on by the compensation committees of many public companies is to grant equity securities, such as shares of stock or stock options, to key employees. This strategy aligns the economic interests of owners and managers, because the employees benefit from an increase in the value of the underlying enterprise.

While the granting of equity securities to incentivize managers is a practical solution in a publicly traded company, the vast majority of businesses are not publicly traded. The nonmarketable minority interests of privately held businesses present a number of complications when used as incentive securities. For example, options of a Subchapter S corporation may be treated by the IRS as a second class of stock, causing the S election to be lost. Further, securities of any pass-through entity (such as an S corporation, partnership, or LLC) issued to incentivize employees may complicate the tax situation of both the employee and the employer.

For these and other ...