Synthetic equity is a versatile solution for companies wishing to engage and reward employees in ways that tie the incentives to business performance, individual contribution, or other criteria. Stock options, stock appreciation rights (SARs), and deferred compensation plans are forms of synthetic equity. They offer the financial advantages of owning company stock without granting actual equity.
For S Corporations already structured as Employee Stock Ownership Plans (ESOPs), the benefits of providing synthetic equity to employees who already hold vested interest may not be readily apparent.
However, by integrating synthetic equity into compensation strategies, ESOP companies can enhance employees’ sense of ownership while also flexibly managing equity and tax efficiencies.
A decision to supplement your ESOP with synthetic equity must be carefully considered, using the following key factors as a guide.
1. Strategic goals and objectives
A synthetic equity strategy isn’t stand-alone. Implementation must align with an ESOP company’s defined overall objectives. Short- and long-term goals such as growth targets, employee retention, and recruitment plans all play into if and how synthetic equity supports the larger corporate strategy.
2. Synthetic equity plan design
A synthetic equity plan needs to fit a company, meaning that the offering — stock options, SARs, or deferred compensation — is in line with the size, culture, and industry. Doing so enhances the appeal of synthetic equity and makes it a meaningful incentive for employees and job candidates alike.
Plan credibility must also be considered. The use of valuation and performance metrics for determining value and payouts is a common approach to establishing transparency and fairness.
3. Tax implications
When ESOP-owned S Corps offer synthetic equity, there are certain tax implications, including:
- Maintaining tax-exempt status, with the caveat that synthetic equity is managed to ensure the structure and distribution complies with all prevailing tax laws.
- Not being able to deduct distributions paid on ESOP shares since they are not considered dividends for tax purposes. This may impact a company’s overall tax and synthetic equity strategies.
For employees, the tax benefits of synthetic equity largely revolve around the timing of taxation and the potential for favorable tax treatment under certain conditions, such as deferred taxation and capital gains considerations. These tax advantages provide attractive upsides — the potential for ownership-level benefits without the immediate tax implications of receiving actual stock.
4. Regulatory compliance
Synthetic equity is subject to regulation under prohibited allocations by an ESOP. An ESOP company pursuing a synthetic equity offering must adhere to IRC Sections 409(p), 409A:
- IRC Section 409(p) specifically targets S Corp ESOPs in relation to equitable benefits distribution among employees, and keeping disqualified persons from receiving excessive ESOP share allocations. Non-compliance with this regulation can bring about significant tax consequences.
- IRC Section 409A applies to deferred compensation plans, including many forms of synthetic equity. The regulation defines timing of deferral elections and distributions. Non-compliance could result in IRS penalities. Companies must be mindful that their synthetic equity plan is structured so as to not inadvertently trigger IRS Section 409A ramifications.
5. Employee perceptions and expectations
Synthetic equity bolsters employee engagement and pride of ownership. Tying incentives to company performance aligns employees’ interests with corporate goals, which fosters motivation, productivity, and loyalty. It also boosts retention as employees can see how they impact their own futures by contributing to the success of the company.
There is also a link to improved recruitment efforts. Synthetic equity offerings in addition to an ESOP can be attractive to job candidates, creating a competitive advantage for your company in securing top talent and potentially boosting your employer brand.
Determining if implementing a synthetic equity plan alongside your S Corp ESOP is a decision that requires attention to detail and guidance from a trusted consultant such as ESOP Partners. We can offer advice on how to structure and maintain compliance programs that achieve your intended goals, and fairly incentivize employees.
Maybe you’re not quite ready to step into synthetic equity. Perhaps you’re just now considering selling your company to an ESOP and have some questions. Explore your options by downloading our guide, What to Expect After the Transition to an ESOP Company.
