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Subject: |
Don't Give Stock To Your Employees; Make Them Pay |
| Date: |
2009-03-30
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Don't Give Stock To
Your Employees; Make Them Pay
By Cliff Ennico
www.creators.com
"I have been running a successful distribution business for several
years. I have two or three key employees that I would hate to lose.
Because of the economy my business has fallen off, and I'm thinking
about asking these people — actually, all my employees — to take a
reduction in pay or reduced work hours. Because I don't want to lose
these key people, though, I'm thinking about giving them some stock in
my corporation so that when the economy gets back on track they will be
able to grow along with it. What do you think about this, and what are
some of the legal things I need to think about before I make them this
offer?"
Whenever you have key employees in any business, it's always a good
idea to make them part owners of the business so they are motivated to
stay on board during difficult times.
The problem here is that your business has been in operation for
several years, so it has an actual value. By "giving" stock to your key
employees, you will be creating a tax headache for them, because the
IRS sees this as part of their overall taxable compensation.
The IRS rules here are really very simple. If you mow my lawn and I pay
you $20, that $20 is income to you. You must report it on your annual
tax return and pay taxes on it. If you mow my lawn and I give you a
share of stock that's worth $20, the result is exactly the same. You
must report $20 on your annual tax return and pay taxes on it. Now, the
last time I looked, you can't pay your tax bill with shares of stock,
so you will have to come up with some cash to pay the taxes on that
$20. The $20 you have to report is called "phantom income," because you
never actually received cash money.
When a company is first getting started, it's OK to "give" stock
(called "founders' shares") to the people who will make the business
successful. Because the company has no real value, neither does the
stock, so there is no "phantom income." Because your company has an
actual value, giving stock to your key employees will require them to
report "phantom income" in an amount equal to the value of your company
multiplied by the percentage they own. For example, if your company is
worth $100,000, and you give an employee stock equal to 1 percent of
the outstanding shares, the employee will have $1,000 in "phantom
income" and will have to pay taxes on it come tax time.
You can't really avoid "phantom income" in a situation like this, but
here's a way you can reduce its impact on the employee:
- First, have your company
valued by your accountant or a local business valuation firm;
- Then, figure out what
percentage of the company you want each key employee to have;
- Multiply the value of your
company by that percentage, and make that the "purchase price" the key
employee will pay for his or her stock;
- Have each employee sign a
"promissory note" agreeing to pay this purchase price three or four
years down the road, plus interest; and
- Then, keep the employee's
salary at the same level, but apply a portion each payroll period to
pay off his "promissory note" — this effectively reduces the employee's
cash salary as you were planning to do anyway.
Because the employee is paying
fair value for his stock, the purchase price would not be "phantom
income" to the employee.
The payroll deductions reducing the note would be "phantom
income" to the employee, but the tax liability would be spread out over
three or four years rather than payable all at once. The employee might
also be able to deduct the interest portion of each payment on his
note, reducing the "phantom income" even further (although the interest
payments will be "phantom income" to your company).
The numbers get a little tricky in a transaction like this, so be sure
a good accountant or tax lawyer helps you put it together.
Since you are currently the sole shareholder of your corporation, make
sure your lawyer prepares a "shareholders' agreement" between you, your
company and all of the new employee-shareholders spelling out their
rights and obligations as shareholders of your company. I would
strongly recommend that their shares be "non-voting" so that you keep
control over your company and how it conducts business.
What if you put this deal together and one of your key employees quits
anyway? The transaction documents should provide that the ex-employee's
"promissory note" will terminate, and he will receive only the shares
of stock he's already paid for — no more than that. If the employee is
terminated "for cause" (he steals money from your company, for
example), he should receive no stock at all.
Cliff Ennico (cennico@legalcareer.com)
is a syndicated columnist, author and former host of the PBS television
series 'Money Hunt'. This column is no substitute for legal, tax or
financial advice, which can be furnished only by a qualified
professional licensed in your state. To find out more about Cliff
Ennico and other Creators Syndicate writers and cartoonists, visit our
Web page at www.creators.com.
COPYRIGHT 2009 CLIFFORD R. ENNICO. DISTRIBUTED BY CREATORS SYNDICATE,
INC. Permission granted for use on DrLaura.com.
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