What Are Performance Shares and Performance Share Units, and How Can They Be Used as Incentive Compensation by LLCs Taxed as Corporations?

Greetings, esteemed readers! Congratulations on making it through our first ten illuminating articles on incentive compensation strategies for LLCs taxed as corporations. Your commitment to scaling these formidable learning heights is an impressive testament to your dedication to bettering your business acumen. Today, we forge ahead into our eleventh exploration, casting our spotlight on two powerful tools for incentivizing your employees—performance shares and performance share units. So, strap in and let’s take this knowledge journey together.

Understanding Performance Shares and Their Taxation

Performance shares, the first tool we’ll delve into, are essentially a promise from the company to its team members. This form of incentive sees the company pledging a target number of shares to a team member, placing them in escrow until they “vest,” or become available. These shares are not merely handed over without a catch. Their earning is contingent on the team member’s performance against specified criteria over a designated period, typically three years. Think of it as a milestone-based reward; the better your performance, the more shares you earn. Interestingly, depending on the performance, it’s possible for team members to earn anywhere from 0% to 200% of the target number of shares. The cherry on top? The final award value also hinges on the company’s stock price.

That said, understanding the tax implications of performance shares is an essential aspect of considering them as an incentive. There are no taxes due at the time of grant. However, when these shares vest, the scenario changes. The fair market value (FMV) at vesting is recognized as ordinary income for the team member. On the company’s side, a corresponding deduction comes into play, aligning with the amount recognized by the team member. Now, when it comes time to sell, any gain or loss is treated as capital gain or loss. This is calculated on the difference between the sale price of the stock and the FMV at the time of vesting. Clearly understanding these tax implications is key in effectively leveraging performance shares as an incentive tool.

But before you leap headfirst into the world of performance shares, let’s take a moment to weigh the potential perks against the possible pitfalls.

The Bright Side

1. Performance shares spark that get-up-and-go attitude in your team members, igniting their passion to crush specific performance targets.
2. Your shareholders and advisory groups will cheer you on, as performance shares are a crowd-pleaser in their circles.
3. Imagine the thrill among your team members when they realize these shiny awards don’t cost them a penny!

The Flip Side

1. If your team members get wind that they’re unlikely to hit the set goals during the performance period, the appeal of performance shares might start to fade.
2. Determining whether those performance goals have been met can turn into a bit of a brain teaser. You might need to brush up on your analytics skills!

So, there you have it – the pros and cons of performance shares in a nutshell.

Understanding Performance Shares Units and Their Taxation

Shifting gears, let’s delve into Performance Share Units (PSUs). A PSU is a company’s unfunded, unsecured promise to bestow a target number of shares to team members in the future, given that specific performance targets are achieved over a set period, often three years. A unique feature of PSUs is that each unit is equal in value to one share of the company’s stock, establishing a clear, tangible link between the team member’s efforts and their potential rewards.

For PSUs, there’s no tax event at grant, provided the PSUs are structured to comply with or be exempt from Section 409A. As with performance shares, no taxes are due at the point of grant or vesting (if compliant with Section 409A), but FICA taxes apply to the FMV at vesting. The settlement phase is when ordinary income is recognized, and at the point of sale, capital gains or loss kick in.

If you thought PSUs sound like a smooth ride, it’s time to unpack the advantages and potential speed bumps that they bring along.

The Bright Side

1. Like performance shares, PSUs inspire your team to meet specific performance targets.
2. Your shareholders and advisory groups are likely to give a big thumbs up to PSUs.
3. Your team members can hold on to their wallets; these awards come at no cost to them.

The Flip Side

1. Team members holding PSUs aren’t beneficial owners, which means no voting or dividend rights. However, the company might offer dividend equivalents to sweeten the deal.
2. Structuring PSUs to comply with or be exempt from Section 409A can be a legal tightrope walk.
3. Determining whether those performance goals have been hit could test your analytics acumen.

So, that’s your sneak peek into the world of PSUs! Keep this balanced view in mind while choosing the best incentive compensation tool for your company.

Conclusion

We hope this article has been informative and useful for your business. If you have any questions or comments, please contact us at info@wilkinsonlawllc.com. We plan to answer general questions in an upcoming FAQ series. If you need legal advice specific to your situation, please ask to schedule a consultation with an attorney to discuss your company’s goals.

Join us tomorrow as we continue to decode the intricacies of incentive compensation with our next piece, “How can LLCs taxed as corporations use time vesting or performance vesting in incentive compensation?”

This article is for informational purposes only and should not be relied upon as tax or legal advice. Please consult professionals for advice tailored to your specific situation. The author and publisher assume no responsibility for any errors or omissions or for any actions taken based on the information presented.