For Family Offices, a key focus is employee retention. Compensation structures, specifically employee incentive compensation plans, are a method for Family Offices to retain high-performing talent. Different types of employee incentive compensation structures have different purposes. Therefore, it is important for these organizations to understand the different approaches and what aligns best with their business goals.

Bonus

In addition to a base salary, employees of a Family Office may receive a cash bonus linked to various measures, such as the performance of the individual or the investments of the family. The organization can determine how often to pay a bonus, whether it be annually or once performance-based measures are met. When bonuses are paid, the bonus is treated as ordinary income to the employee and taxed accordingly. If it is the intention of the Family Office to provide a certain level of after-tax bonus amount to the employee, the Family Office would have to gross-up the bonus for the taxes. This is often the simplest and most efficient way to implement an incentive-based compensation plan.

Long-Term Incentive

Similar to cash bonuses, long-term incentive plans are based on various measures. However, they focus on long-term outcomes. Under a long-term incentive plan, the employee will earn compensation over several years, often using vesting schedules or performance-based measures to determine when payouts will occur.

Pay-outs may occur at the following events:

• Separation from service,
• Death,
• Disability,
• Specified date,
• Change in control, or
• When performance measures are met

These pay-outs may include cash or equity, depending on the plan, all tied to the long-term growth of the business. For tax purposes, these compensation plans will be treated as ordinary income to the employee when received, and employers will withhold the appropriate payroll taxes on the cash or equity being paid out. If an employee receives equity, any future sale the employee makes will be treated as capital gain to the employee, short or long-term, depending on the holding period.

Phantom equity is often used within a long-term incentive plan framework. This replicates real equity in a company without providing voting rights or granting real ownership. As a company’s equity appreciates, the phantom equity liability also grows. The phantom equity is paid out in cash at a certain date and results in ordinary income for the employee. Unlike stock options and restricted stock units, this does not result in the employee receiving equity. Instead, the employee will receive cash based on the value of the business’s equity at certain points in time.

Carried Interest

Carried interests are an employee incentive compensation plan often used when trying to incentivize investment professionals. A carried interest represents the employee’s ability to receive a percentage of profits from a business or investment through an allocation of income and corresponding cash distribution from a partnership. This is commonly associated with a threshold, also referred to as the hurdle or preferred return. Once the hurdle is met and performance measures are achieved, the employee will earn a percentage of the investment profits. The hurdle is predetermined in the partnership agreement and is often associated with a distribution waterfall. A distribution waterfall dictates the ordering of cash distributions from a particular investment partnership. Most distribution waterfalls first return invested capital plus a preferred return on that capital prior to any distributions to a carried interest.  From an income tax perspective, carried interests are generally not taxed when issued.

There are many issues to be aware of with carried interest structures. In many instances, carried interest recipients will receive allocations of taxable income prior to receiving any cash distributions under the waterfall.  This is a common issue due to the difference in the way tax allocations function when compared to the functionality of the distribution waterfall. To address this issue, many agreements will include tax distribution provisions so that carried interest holders can receive advances on their future distributions to pay the taxes associated with these types of taxable income allocations. It is important to constantly project taxable income allocations as realizations occur to ensure appropriate tax distributions are made. 

Complications with a carried interest can occur when carry percentages shift. Such a shift can occur when there are forfeitures, buy-outs, increases, or decreases in the carry percentage due to changes in performance or other changes to the partnership agreement. When these percentages shift, the cash distributions and income allocations may need to be adjusted to ensure investors are receiving the portion of profits and cash to which they are entitled. In addition, it is important to consider whether any gain or loss is recognized outside of the investment partnership by the carried interest holder in the instance of a forfeiture or buy-out, as this can result in necessary basis adjustments to the assets of the partnership.

The Takeaway

When implementing an employee incentive compensation plan for a Family Office, it is important to consider a variety of factors, including the administrative complexity, the alignment of employee incentives with those of the family, and the income tax consequences of different types of plans. It is therefore critical that family offices and their employees be properly advised as to these issues.