In the private company context, high-performers, senior executives and other vital employees are a company’s lifeblood. It is therefore critically important to retain these top performers, which often requires that the company’s majority owners provide these key employees with significant financial rewards. Simply paying top performers additional cash compensation or issuing them shares of an illiquid ownership interest may not be the best approach. But issuing units or shares to employees will dilute the company’s ownership and could also expose the company’s majority owners to future claims for breach of their fiduciary duties. 

An alternative means of compensating top performers may be providing them with stock appreciation rights or what is known as phantom stock. This post reviews some of the pluses or minuses involved when majority owners are considering whether to issue these types of non-equity awards to the company’s highly valued employees.

Issuing Equity Grants to Key Employees Can Create Problems

The desire for an alternative to providing key employees with stock or units in the company is spurred by several factors. First, many companies are closely held and/or have elected Subchapter S tax treatment, which restricts the number of owners the company may have. Second, in closely held companies, the existing owners may be reluctant to have their ownership interest diluted by granting stock options to employees or issuing shares of stock or membership units to them. Third, granting equity to employees provides these new owners of the business with significant new rights, which may include, but are not limited to: (a) calling an owners’ meeting and including items on the agenda for discussion, (b) demanding access to the company’s financial books and records, (c) filing claims against the majority owners on a derivative basis for breach of fiduciary duties, and (d) receiving payment for their ownership stake in the event of a sale or IPO.

In short, once employees are issued equity in the company, they become co-owners of the business, and the majority owners need to be prepared to share ownership of the company and other rights of company governance with these new partners. Therefore, the majority owners need to be aware that their new minority partners will be authorized to assert a number of rights and/or claims against the company and its majority owner(s) that may result in conflicts that can disrupt the business. These concerns must be juxtaposed against the need for the majority owner to provide employees with some kind of “skin in the game” to incentivize them to remain top performers.

What Are Phantom Stock and Stock Appreciation Rights?  

Fortunately, the problems for majority owners discussed above that result from the issuance of equity to employees can be avoided through creative business solutions that do not make the employees new business partners. Specifically, the majority owner can issue stock appreciation rights (SARs) or phantom stock units to these key contributors to the business. These rights are sometimes referred to as “synthetic equity” because they provide employees with a contractual “piece of the pie” that does not give them an actual ownership stake in the business. And these synthetic equity grants can be based on actual shares of stock or other units of ownership, such as membership units.

A SAR is a right granted to an employee with respect to one or more shares of stock (or membership units) that entitles the employee to receive a cash payment for each SAR based on the performance of the business. This is akin to a cash bonus that is equal to the excess of the fair market value of a share of stock or unit on the date of exercise over a specified price, usually referred to as the “initial price” or “initial value” of the SAR. In other words, when the price of a share of the company’s stock increases over a set period, the employee receives a cash payment based on a defined formula. SARs are typically subject to a vesting period, often based on the passage of time, but they could be based upon achievement of other metrics.

As a simple example, an employer grants an employee 10,000 SARs with an initial value of $10 per share (which is equal to the fair market value of the company’s stock on the date of the grant). Sometime later the employee “exercises” the SARs, similar to the manner in which an employee would exercise a stock option, the only difference being that the employee is not required to pay any amount up front to acquire the SAR.

At the time the SAR is exercised by the employee, the fair market value of the company’s stock is $20 per share. As a result, upon exercise, the employee receives a cash payment — and thus taxable compensation — in an amount equal to $100,000 (the difference between the current fair market value of $20 per share and the “initial value” of $10 per share, multiplied by the number of SARs granted to the employee, or 10,000). The company will realize a corresponding tax deduction for the payment of this additional compensation. Payment of SARs may be in cash, stock, or both, but they are most often paid in cash, as payment in stock would be dilutive and counter to the notion of “synthetic equity.”

Phantom stock units, like SARs, are also based on the value of underlying stock or membership unit. The difference between phantom stock units and SARs is that rather than receiving a cash payment upon exercise equal to the appreciation in the underlying employer stock, over some “initial value,” the recipient of phantom stock units receives the actual value of the shares of the underlying stock, multiplied by the number of phantom stock units held by the recipient. As with SARs, awards of phantom stock are typically subject to a vesting period.  

As an example, an employee receives 10,000 phantom stock units. The fair market value of the company’s stock at the time the phantom stock units were granted to the employee is generally not as important as it is with respect to SARs, which use an “initial value.” When the phantom stock units are paid, the employee receives the actual fair market value per share of employer stock at that time. Therefore, if the fair market value at the time of payment was $20, the employee would receive $200,000 ($20 per share multiplied by 10,000 phantom stock units).  Unlike SARs, however, the employee received value when the phantom stock units were granted.  In the example above, if the value of the underlying employer stock was $10, the employee has $100,000 of value on the grant date. If this were a SAR with an initial value of $10 per SAR, there is no value of any kind unless and until the value of the underlying stock appreciates above $10.

Federal Income Tax Treatment

There is no tax due when an employee receives a grant of a SAR or phantom stock units; taxes become due only upon exercise and payment. An employee who has vested SARs or phantom stock units is not in “constructive receipt” of income upon vesting, and thus the employee has not received any ordinary income simply by virtue of the vesting and appreciation of the employer’s stock. Rather, the cash payment to which the employee is entitled is included in the employee’s gross income for the year in which the SAR or phantom stock unit is exercised or paid, at which time the employee receives ordinary taxable income that is subject to withholding similar to normal compensation payments. The company also receives a corresponding tax deduction equal to the amount included in the employee’s income when the employee is taxed upon exercise of the SAR or the payment of the phantom stock unit.

Conclusion: Advantages and Disadvantages

The advantage to the employee of receiving a SAR is that it provides him or her with the potential opportunity to receive large payments from the company while avoiding the need to provide any cash outlay that is associated with buying stock options or actual stock in the company. With certain exceptions due to the impact of Code Section 409A, the employee can also control the timing of exercise with respect to a SAR (but cannot do so with respect to phantom stock units due to Code Section 409A requirements). From the company’s perspective, the employee gains parallel shareholder gains. The employee has no gain unless the share value increases. Finally, the holder of a SAR is not considered a shareholder. Thus, performance-based stock compensation can be awarded without increasing the number of shareholders or otherwise diluting existing shareholders.

Like SARs, the advantage of phantom stock is that it provides a means for the employer to compensate an employee with the value of company stock without having to issue actual shares stock. Similar to SARs, the employee has the potential to receive large gains and yet avoids the financing costs of options and stock ownership. Unlike a SAR, however, the employee who receives a phantom stock unit can receive substantial value even if the company’s stock performs poorly. Based on the example above, if the value of company stock decreased from $10 to $5 per share, the employee would still receive a cash payment of $50,000 based on the ownership of the phantom stock. With a SAR, if the value of the company’s stock declines or remains the same, the employee receives nothing. 

There is one additional, significant benefit to majority owners for issuing SARs and phantom stock to key employees rather than providing them with actual equity. These types of synthetic equity provide contractual benefits, and the employee must therefore remain employed by the company to receive them – this is a “must be present to win” component. When actual stock is issued to employees, the company or majority owner has to repurchase the shares when the employee resigns or the employment is terminated, which can lead to conflicts about the value of the stock being redeemed. With SARs and phantom stock, however, these rights are extinguished automatically when the employee departs from the business and, therefore, there is no stock or ownership interest the majority owner or the company needs to repurchase.   

Divorcing spouses often have a number of business issues to resolve, but one key aspect that is often overlooked takes place when divorce settlements involve the division of an ownership interest in a private company.  Typically, the business is not a party to the divorce, but the absence of the company as a named party does not mean that financial or other business issues relating to the company should not be addressed by the parties in the settlement agreement. If spouses fail to consider and deal with issues relating to the company when they negotiate their divorce settlement, that may lead to adverse future results for the spouses and also for the company in the future.

This post reviews some of the important issues that spouses will want to consider when they negotiate the terms of the division of their ownership interest in a private business. 

Settlement Agreement Should Confirm Full Transfer of All Rights and Ownership Interests

It sounds straightforward to confirm that whenever a spouse transfers his or her ownership of an interest in a private business in a divorce settlement (the “transferring spouse”), the documents that confirm this transfer must make clear that the spouse is conveying all interests and rights held by the spouse in the company.  But, it is essential to use language that makes this clear, because an ownership interest in a private company may include many different rights, including the right to receive dividends or distributions, retirement contributions, health benefits, deferred compensation and reimbursement of expenses, among others. It is therefore critical to make sure the transfer of these interests and rights to the receiving spouse is carefully documented in the parties’ divorce settlement. The settlement agreement should therefore include language that is broad and inclusive to reflect the parties’ intent that the transferring spouse will not retain any ownership interest or rights of any kind in the company and will not receive any future benefits or financial consideration from the company or from the other spouse in the future.

Transferring Spouse Should Secure Release from the Company

It is common for divorce settlement agreements to include a mutual release in which each spouse releases the other from all claims that existed as of the date of the divorce. It is less common, but also important, for the transferring spouse to secure a release in the settlement agreement from the company of all claims that the company may have against that spouse. A release granted by a spouse likely does not constitute a release by the company, as well, because the company is a separate legal entity, i.e.,the company has its own rights that are separate and independent from the rights of the receiving spouse (the spouse receiving the transferred interest). The transferring spouse will therefore want to make sure to receive a release from the company that prevents it from bringing any claims against him or her after the divorce becomes final.

Transferring Spouse Should Also Seek Indemnity/Insurance Protection

In addition to securing a release from the company, the transferring spouse should also seek to obtain an indemnity from the company that provides protection in the event that a lawsuit is filed in the future in which the spouse is named as a party.  An indemnity provision will require the company to pay for counsel for the transferring spouse and cover any liability that results in future litigation. The transferring spouse should also request that the receiving spouse arrange for the company to extend the protection of the company’s directors and officers insurance (D&O) policy if one exists. This type of policy extension will provide continued insurance coverage to the transferring spouse under the policy for some period of years after the transfer takes place. This is referred to as “tail coverage,” and it is generally available for a reasonable cost to the company, but the continued coverage will likely be made available only if it is requested and obtained at the time of the divorce. 

Potential Non-Compete Restriction and Protection of Intellectual Property

A final point relates to the operation of the business after the divorce becomes final. The receiving spouse should consider whether the transferring spouse poses a competitive threat to the company after the divorce. If so, the receiving spouse may want to request that the transferring spouse accept some type of non-compete restriction in the terms of the divorce settlement. In this situation, the receiving spouse will likely need to provide additional consideration to the transferring spouse to compensate that spouse for accepting this restriction on future employment or business opportunities, and these terms will be subject to negotiation between the parties.

In addition, to protect the company’s trade secrets and confidential information, the receiving spouse will also want to include confidentiality restrictions in the divorce settlement that apply to the transferring spouse. The receiving spouse should not be required to provide additional consideration in the divorce settlement, however, for requesting that the transferring spouse continue to maintain in confidence all of the company’s trade secrets and confidential information after the divorce. 

Conclusion

When spouses divide assets of their marital estate in a divorce settlement, they will want to consider issues that arise when they own an interest in a private company that is transferred to the other spouse in the divorce settlement. Specifically, the couple will want to consider issues that relate to their rights as owners of the business and also determine what is in the company’s best interests after the divorce has concluded.  If the couple fails to give the company a seat at the table during the negotiation of the divorce settlement, this omission may give rise to significant future problems and conflicts between the spouse that they could have addressed in their divorce settlement.  

Corporations and LLCs both provide their shareholders and members with limited liability to operate a for-profit business, and while these two forms of business entities are similar in many ways, they also have some important differences. For example, there are key distinctions between corporations and LLCs in their ability to modify or eliminate the fiduciary duties that the directors, officers, or managers owe to the corporation or to the LLC.

Once they have been formed, corporations may also be converted to LLCs (and vice versa). These conversions come with a number of consequences, however, and should therefore take place only after careful analysis. This post reviews some of the corporate governance, tax, and disclosure considerations that shareholders of a corporation may wish to evaluate before converting their corporation into an LLC.

Converting a Corporation to an LLC Under Texas Law

The shareholders of a corporation may make the decision to convert the form of the business into a limited liability company by adopting a plan of conversion under Section 10.101 of the Texas Business Organizations Code and by filing a certificate of conversion with the Texas Secretary of State under Sections 10.154 and 10.155. The conversion may take place immediately or it may become effective as late as 90 days after filing.

Intended Consequences: Corporate Governance Flexibility

One important reason that shareholders may wish to convert their corporation into an LLC is that it provides a business with greater flexibility in matters relating to corporate governance.

By law, the powers of a for-profit corporation are exercised or authorized by its board of directors, which directs both the management and affairs of the corporation. Tex. Bus. Orgs. Code § 21.401(a). A for-profit corporation must have at least one director, a president, and a secretary, although the same person may serve in all of those roles. Id. §§ 21.403(a), 21.417. The officers and directors of a for-profit corporation owe fiduciary duties to the company of obedience, loyalty, and due care. See Ritchie v. Rupe, 443 S.W.3d 856, 869 (Tex. 2014). These fiduciary duties may be mitigated (but not eliminated) through limits adopted in the bylaws, see Tex. Bus. Orgs. Code § 7.001(b), (c), or through permissive indemnification. This allows a corporation to indemnify a director or officer who breaches his or her fiduciary duties of obedience and care (but not the duty of loyalty), if the director or officer acted in good faith and reasonably believed that his or her conduct was in the corporation’s best interests, id. §§ 8.101(a), 8.102(b). Providing indemnification to directors and officers encourages them to make decisions for the corporation without fear of incurring personal liability if their decisions turn out poorly, so long as they made those decisions loyally and in good faith. See Hibbert v. Hollywood Park, Inc., 457 A.2d 339, 344 (Del. 1983) (explaining the indemnification’s “larger purpose is to encourage capable men to serve as corporate directors” (internal quotation marks omitted)).

LLCs permit their members more flexibility in these governance matters. More specifically, LLCs are run according to the terms of a company agreement, which sets out the relations among the members, managers, and officers of the LLC. Tex. Bus. Orgs. Code § 101.052(a). Unlike a corporation, which must be managed by a board of directors, an LLC may be run directly by its members (owners), or by managers (who are appointed by the members). See id. § 101.101. Further, unlike corporations, LLCs afford substantial flexibility to expand or restrict the fiduciary duties that governing persons owe to the LLC and its members. See id. §§ 7.001(d)(3), 101.401. There are risks associated with investing in an LLC that is run by persons who owe restricted fiduciary duties to the LLC or its members, and investors should carefully consider those risks before investing.

Intended Consequences: Tax Consequences of Conversion

The conversion of a C corporation to an LLC is a significant taxable event, because the conversion is treated as a distribution of all of the corporation’s assets and liabilities to its shareholders in exchange or a surrender of their stock. Thus, a corporate conversion to an LLC has the potential to generate a substantial tax bill, and shareholders will want to carefully consider the tax consequences before moving forward to convert a C corporation into an LLC.

Unintended Consequences: Disclosure of Ownership

Shareholders who choose to convert a corporation into an LLC have likely evaluated the corporate governance and tax consequences of the conversion. But there may also be other, unintended consequences. One example came to light in a recent case involving federal court jurisdiction.

As a general rule, a lawsuit can be filed in federal court if it involves a federal question – interpretation of a federal law or of the U.S. Constitution – or if it involves diversity jurisdiction. Diversity jurisdiction comes into play when all of the parties bringing suit are citizens of different states than all of the parties being sued. Individuals are citizens of the state in which they are domiciled – a maximum of one state. Corporations are citizens of the state where they are organized and of the state where their principal office is located – a maximum of two states. LLCs, on the other hand, are citizens of every state where one of their members has citizenship. If one of an LLC’s members is also an LLC, then the citizenship of that second LLC’s members is also the citizenship of the first LLC. Depending on how many members an LLC has, and whether any of those members are LLCs, this can lead to citizenship in many jurisdictions.

In Ben E. Keith Co. v. Dining Alliance Inc., the plaintiff brought suit, invoking the federal court’s diversity jurisdiction to assert claims under state law. The plaintiff had not been aware, however, that the defendant had converted from a corporation to an LLC before the lawsuit was filed. As discovery progressed, the parties realized that diversity jurisdiction may not have existed when the case was first filed. By that point, the parties had added federal claims, the defendant had filed counterclaims, and the defendant had filed third-party claims against new parties. The court ordered the parties to establish their citizenship to confirm that diversity existed to support federal court jurisdiction, which required the LLC defendant to identify each of their members and their citizenship. As it turned out, the LLC defendant had members who were also LLCs or partnerships, and it claimed that some of those members had a complex ownership structure that included multiple tiers of partnerships and funds whose citizenship it was not able to determine. The court ultimately sanctioned the LLC defendant by dismissing all of its counterclaims and third-party claims with prejudice.

Conclusion

There are a number of factors that corporate shareholders should take into account before converting their corporation into an LLC. These include the flexibility of corporate governance and management after conversion and the potential tax consequences of undertaking the conversion. But there are other potential consequences, including disclosing the identities of an LLC’s members if the LLC is (or becomes) involved in litigation in federal court. Shareholders should undertake the process of converting a corporation to an LLC only after carefully considering these and other possible consequences.