In the current labor market, incentivizing employees with an equity stake in a veterinary practice is becoming a requirement, not an optional perk, for attracting and retaining quality doctors and support staff. We want to address the traditional means for granting equity interests (and the downsides) as well as the advantages of newer, non-traditional methods.
An employee stock option plan (ESOP) for professional corporations or an employee unit option plan for a professional limited liability company is the more traditional means of granting equity in an employer’s entity as a form of compensation. While the terms of these option plans can vary greatly, the essential elements are the same. An employee gets the opportunity, or option, to purchase shares, or units, in the entity at a specified price over a limited period. Generally, a vesting schedule allows the employee to buy a certain number of shares each time a set number of years of employment is achieved. The employee has a limited window for exercising the options. The option plan comes with a preferred price, meaning a price set below the shares’ actual value.
Tax Implications
Option plans have several downsides for the practice and employee. First, the employee must be able to pay for the shares. The practice can “lend” the purchase price to the employee, though no money changes hands. Nevertheless, the employee must repay the loan or suffer an adverse tax consequence. Further, if the practice forgives the loan, the employee has an ownership interest but didn’t pay for it. In addition, when an employee purchases shares at a price below fair market value, the difference is considered taxable income.
Finally, these types of option plans pose an entrepreneurial risk that some employees are unwilling or financially unable to accept. The danger is that the practice and employee’s interest don’t increase in value over time and might even decrease. Another risk is that the veterinarian owner, as the majority owner, can control how much money is left in the practice to present as dividends or distributions to the minority owners.
Profits Interests
If the veterinary practice is taxed as a partnership for federal income tax purposes, granting employees a profits interest in the entity is another form of equity compensation. Such a move avoids essentially all the previously mentioned downsides and benefits both the employer and employee in other ways.
A profits interest grants real equity, or ownership, in the practice entity, but as the name indicates, the holder receives an interest limited to a portion of the employer’s future profits. The limit is why a profits interest is often the preferable way to grant equity compensation to employees.
A profits interest is an outright grant of an equity compensation benefit, while under an option plan, the employee decides whether to exercise the option to purchase and pay for shares. The employee does not pay for the profits interest because it is granted in consideration of services to the employer.
Employees who receive a profits interest do not owe income taxes at the time of the grant.
An employee can benefit from a profits interest in two situations. First is when the entity is sold entirely or partially. However, in many cases, such a liquidity event occurs so far into the future that employees might not be sufficiently incentivized to perform at their utmost to enhance the practice’s value. Therefore, we recommend that the profits interests provide employees with a yearly distribution of a share of profits and a share of the proceeds at the time of a liquidity event. Such a structure can be combined with a vesting schedule to enhance employee loyalty.
Spreading the Wealth
A veterinary practice has great flexibility in structuring how a yearly profits distribution is calculated and allocated among the owners, including the holders of a profits interest. Consequently, the annual distribution can be proportionate to the number of profits interest units. For example, if 1,000 units are authorized and outstanding, the holder of 100 units is entitled to 10% of the practice’s profits for that year. The employee will pay ordinary income tax on the payment.
Another method is to fix the amount of profits that must be realized by the year’s end. Then, only the earnings above that set amount, or floor, are distributed to the holders of general equity units or profits interest units. The advantage of this structure is that the practice owners, who invested capital, took the entrepreneurial risks and drove the practice’s success, receive a certain level of return on their investment before additional profits are given to employees as compensation for their service.
In addition to the tax advantages, the veterinarian owner has tremendous flexibility in fashioning the compensation granted to employees in the yearly distribution of profits and at the time of a liquidity event. For example, a practice owner with multiple locations might want to incentivize a veterinarian with profits from the doctor’s hospital only. This structure can include a profit floor so that the employee receives only a proportionate distribution of additional profits.
Given the complexity and advantages of employee profits interests, consult an attorney before offering equity compensation.