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Offering Ownership to Employees

Business clients often ask whether they should offer employees ownership in the company as a way to encourage employee retention and loyalty. Receiving a stake in the company may provide employees the incentive to stay and share in its eventual financial success. While this may be sound strategy in some instances, we generally advise employers to proceed with caution. Among other things, employers should consider the legal duties owed to stockholders, the employee’s right to review financial records, the costs and complexities of repurchasing the shares upon termination of employment, and securities law compliance. Some of these issues may be adequately addressed in buy sell agreements, employment agreements, restrictive covenants and governing documents, or by issuing only non-voting stock to employee. But there are also significant tax consequences that should be considered.

Generally, any property transferred to an employee in exchange for services is considered taxable income to the employee. This would include automobiles, rent-free use of a company apartment, or shares of the employer’s stock. The employee will be taxed on the difference between the fair market value of the property received and the amount the employee pays for it; the employer would be permitted to deduct that same amount from its gross income. Shares in your business are a valuable asset (believe it or not). If your company is a start-up, the stock value may be minimal, but with time the value should increase and with it the potential tax liability to anyone receiving company stock.

There are a number of available strategies for issuing equity to employees. Which strategy is appropriate for a particular company depends on various considerations, including the type of entity, whether shares will be offered without charge or for a bargain price, whether employees will have the immediate right to purchase shares or whether the right will vest over time, and whether the company will have the right to repurchase the shares upon termination of the employee’s employment.

1. Stock Bonus Plans. Employees may be permitted to acquire shares without paying for them. In that event, the stock would be considered compensation to the employee, and the employee would pay taxes on the full value of the shares at the time of the issuance.

2. Stock Purchase Plans. The employer may allow employees to purchase stock for full value or for a discounted price. To the extent an employee pays full value for shares, no taxable income will be recognized. If shares were sold to the employee for less than fair market value, the employee would be taxed on the difference between the share price and the stock value at the time of issuance. Requiring employees to purchase stock, however, may not be desirable if stock ownership is intended as a benefit.

3. Non-Qualified Stock Option Plans. Stock Options may be an attractive alternative to outright stock ownership. A Stock Option is simply the contractual right to purchase shares at a certain pre-determined Strike Price if certain conditions are met (e.g., the employee remains with the company for a certain number of years). For a non-public company the issuance of a Stock Option itself is generally not a taxable event. Unless the Options are Qualified Incentive Stock Options (discussed below), the employee would be taxed on the amount by which the stock value increases between the date the Stock Options are first granted (Grant Date) and the date the Stock Options are exercised and the stock is purchased (Exercise Date). As time passes, the employer’s stock value may be expected to increase. If the employee were granted a Stock Option at a low Strike Price, but the stock value had doubled by the Exercise Date, the employee would have received a taxable benefit. Assume, for example, a $5,000 Strike Price based on the stock value in 2007. Assume also that the employee were to exercise the option and purchase the option shares in 2015 at the $5,000 Strike Price. If by then the stock value had risen to $15,000, the employee would recognize $10,000 in taxable income (the difference between the $5,000 Strike Price and the $15,000 stock value at the Exercise Date). For purely tax planning purposes, therefore, it may be preferable to issue shares early in the company’s history, when the share value will presumably be lower. Issuing shares early may, however, be contrary to the strategy of rewarding employees for remaining with the company long-term.

4. Qualified Incentive Stock Option Plans (ISOP’s). The tax consequences discussed above can be avoided if the Stock Options qualify as Incentive Stock Options (ISO’s) under Section 421 of the Internal Revenue Code. In order to qualify as ISO’s, the options must be governed by the terms of a formal Incentive Stock Option Plan (ISOP) meeting certain IRS requirements. If ISO’s are issued under a properly adopted and executed Plan, a participating employee will not be taxed on any increase in stock value between the Grant Date and the Exercise Date. Put another way, the employee would be treated as if he or she had purchased the Option Shares on the Grant Date, when the share value would presumably be lower. Incentive Stock Options may, therefore, be a good strategy if employee retention is the goal and the stock value is expected to appreciate significantly in the future.Typically, ISO’s are considered to have been granted at the time the employer and employee sign a Stock Option Agreement which sets forth the specific option terms, including Strike Price, Grant Date, vesting terms, etc. There is no requirement that the same terms be offered to all employees. ISO’s are not qualified plans under ERISA and are, therefore, not governed by the same nondiscrimination rules applicable to qualified plans. Of course, employers are subject to federal, state and local equal employment opportunity laws.

A common strategy is to permit employees to exercise ISO’s upon the occurrence of an acquisition of the company, even if the ISO’s have not yet vested. The options can be structured so that the employee never actually pays cash for the option shares. At or prior to closing, the employee may exercise the ISO’s and “pay” for the option shares by signing a short-term promissory note, and then immediately re-sell the option shares to the party acquiring the business. As discussed further below, however, the simultaneous purchase and re-sale of shares will result in the employee paying taxes on the profit at ordinary rather than long term capital gains rates. Still, the expectation that shares can be liquidated for a tremendous profit in an acquisition can be a powerful incentive to stay with the company for the long haul.

The requirements of an Incentive Stock Option Plan are as follows:

(a) The employer must adopt a formal Incentive Stock Option Plan (ISOP), which, among other provisions, states the maximum number of option shares and defines the class of employees entitled to participate in the Plan. The ISOP must be approved by the stockholders. There is no requirement that the Plan be filed with the IRS. The Plan may, however, be scrutinized in an IRS audit to ensure it complies with the requirements of an ISOP.

(b) Options must be granted within 10 years after the Plan is adopted or approved by the stockholders, whichever occurs first.

(c) A participating employee may be given up to 10 years in which to exercise the Stock Option. Under the tax laws, the ISO’s must terminate no later than 10 years after the Grant Date. (For employees who already own at least 10% of the employer’s shares, ISO’s must be exercised within five (5) years after the Grant Date).

(d) The Strike Price must be at least equal to the stock value as of the Grant Date. (For stockholders who already own 10% or more of the employer’s shares, the Strike Price must be at least 110% of the stock value). The Strike Price may be higher than the stock value, but it may not be lower. A formal business valuation should be performed in order to establish a baseline stock value as of the Grant Date. The formal valuation will be crucial evidence in the event of an IRS audit.

(e) The ISO’s must be non-transferable by the employee, except upon death (e.g., through the employee’s will).

(f) The Stock Option Agreement will state any terms under which the Stock Options vest. If the employee dies or his employment is terminated, any unvested Stock Options will be forfeited. The employee, or his estate, will have the right to purchase any vested Stock Options for a limited period of time after the date of employment termination or death. As mentioned above, vesting may be accelerated upon a merger or acquisition of the employer, or, alternatively, for the employee to acquire comparable stock options in the acquiring company.

(g) The Stock Option Plan must identify the “class” of employees eligible to participate. The Plan may limit participation to certain employees (e.g., upper management, executive officers, sales personnel, etc.) Or, participation may be open to all employees. Employers may be well-advised to make the “class” of participants as broad as possible, allowing the flexibility to offer stock to as many employees as the employer wishes. Just because employees are eligible to participate in the Plan does not obligate the employer to grant any options. The Plan may provide that all employees are eligible participate, but ultimately ISO’s could be issued to only certain employees designated by the board, or not at all.

(h) The aggregate fair market value of all stock issued for the first time during any calendar year may not exceed $100,000.

(i) Only employees may participate in Incentive Stock Options. Stock Options granted to non-employees (e.g., independent contractors) will not qualify as ISO’s.

(j) Only corporations may grant ISO’s. Limited liability companies (LLC’s) and other entities are not eligible to use ISO’s. As discussed below, there are other tax-advantageous strategies available to unincorporated entities such as LLC’s.

Employees should be encouraged to consult with their personal tax advisors regarding the effect of ISO’s on the employee’s own tax planning. For example, upon first exercising the option, a portion of the value of the option shares may be subject to Alternative Minimum Tax (ATM) to the employee. Also, if the employee purchases and then re-sells option shares, the employee will be taxed on the difference between the price the employee paid for the shares (the basis) and the re-sale price. The employee will pay tax on this spread at long-term capital gains rates only if the employee had held the option shares for at least two years after the Grant Date and at least one year after the employee purchased the option shares. Otherwise, the employee must recognize income at the higher ordinary income tax rates. The employee may, therefore, pay higher taxes if the Stock Options are exercised contemporaneously with an acquisition of the company, a common occurrence with ISO’s.

5. Restricted Stock. An alternative tax strategy to ISO’s would be to actually issue shares to employees now, but have the shares remain unvested until sometime in the future. Such unvested Shares are commonly known as Restricted Stock. Under federal tax law, shares are considered Restricted as long as the shares are (a) not transferable by the employee and (b) subject to a “substantial risk of forfeiture”. Shares issued to an employee are subject to a “substantial risk of forfeiture” if the employee would be required to transfer the shares back to corporation, for a nominal price or the same price at which they were initially purchased, upon termination of employment or some other pre-determined event.Because Restricted Stock is forfeitable and non-transferable, Restricted Stock is deemed to have no taxable value. As such, an employee will not recognize taxable income upon the issuance of Restricted Stock until the shares vest. In the case of Restricted Stock, vesting occurs on the date when the restrictions lapse and the shares are no longer subject to forfeiture. At that point, the employee will recognize income equal to the difference between the price he or she initially paid for the Restricted Stock and the value of the stock at the time of vesting. Assume, for example, that the Restricted Stock Agreement provides that the employee will forfeit the shares if he or she fails to remain employed for at least five years. During that five year period the shares would be considered Restricted Stock (i.e., unvested). If, however, the employee were still employed with the company at the end of the five year period, the shares will vest and the employee would recognize taxable income. If the Restricted Stock Agreement allowed a certain number of shares to vest each year, then the employee will be taxed on the shares as they vest.

Restricted Stock is typically issued to an employee under terms stated in a Restricted Stock Agreement signed by the corporation and the employee. The Restricted Stock Agreement provides the price at which the Restricted Stock will be repurchased upon the employee’s death or termination of employment. The Restricted Stock Agreement may also permit the corporation to repurchase the employee’s shares after vesting, but the purchase price would then typically be commensurate with the share value, as determined by a valuation formula or a formal valuation, as of the time of repurchase (rather than a nominal price).

Restricted Stock is not subject to the same formal requirements as Incentive Stock Options. For example, the employer is not required to adopt a Restricted Stock Plan, although some employers choose to do so. All that is required to qualify as Restricted Stock is that the stock, in fact, is non-transferable and subject to a substantial risk of forfeiture.

Restricted Stock only defers tax liability. In most cases, Restricted Stock is scheduled to vest at some time in the future when, presumably, the stock value will higher. For tax planning purposes, this may give the corporation the incentive to have the shares vest sooner rather than later. Earlier vesting, however, may be inconsistent with the employer’s longer term (non-tax) planning objective to encourage employee retention and loyalty.

One strategy is to require the employee to file an election with the IRS to recognize income when the shares are first issued, even though the shares are unvested. This is known as an 83(b) Election (since it is permitted under Section 83(b) of the Internal Revenue Code). If the election is filed, the employee will be taxed on the value of the shares as of the issuance date, but the employee will not recognize any tax when the stock vests. The tax bill may be modest if the stock value is lower when the shares are acquired, and the employee could avoid an enormous tax bill in the future when the shares vest. This strategy could backfire, however, if the stock value were to ultimately decrease.

One disadvantage of issuing Restricted Stock is that employees become immediate stockholders, with the right to vote and to receive dividends. Also, the duty of loyalty corporate directors owe to the corporation would extend to these employee-stockholders. These disadvantages may be mitigated if the corporation retains the right to repurchase the shares for a nominal value upon termination of employment. We generally advise that the documentation clearly state that the employee remains an “at will” employee regardless of stock ownership.

6. Issuance of LLC/Partnership Interests. Different strategies are available for limited liability companies (LLC’s) and partnerships, both which are subject to partnership tax laws. An employee will not be taxed on receiving an interest in of an LLC or partnership in exchange for services if the employee does not receive a share of the company’s capital. The employee would share in future appreciation in company assets and in future profits and losses, but not in the company’s current capital. Put another way, the employee would have a starting capital account balance of zero dollars.

A future profits interest with zero starting capital account may be less appealing to the employee since there would be no baseline value to the employee’s equity interest. This strategy does, however, eliminate taxable income to the employee resulting from issuance of the profits interest.

This strategy does not work with corporate stock. Unlike partnership and LLC interests, the capital interest and profits interest associated with corporate stock cannot be separated.

7. Phantom Stock. An alternative to equity compensation is to reward employees with creative incentive bonuses, benefits and perks. One such alternative is Phantom Stock, which resembles capital stock but is in fact nothing more than an elaborate bonus arrangement. Under a Phantom Stock plan, the employee would receive a certain number of units which correspond to a percentage of the outstanding stock of the company. For example, one unit may equate to 1% of the outstanding shares of the employer’s stock. Phantom Stock may entitle unit holders to share proportionately in regular dividends paid to stockholders. Or the holders may be limited to a share in the net proceeds from an eventual merger or acquisition of the company. Employees typically receive the bonus in cash, but the plan may permit employees to receive shares of the employer’s stock in lieu of cash.

Phantom Stock resembles “shares” in the company’s future profits, kind of a “pretend stock”. In contrast to real capital stock, however, employees do not pay for their units, and the company is not obligated to repurchase the units upon termination of the employee. Employees also have no voting rights, and corporate directors would not owe the same high duty of loyalty to Phantom Stock holders as they do to real stockholders. In truth, Phantom Stock is not stock at all, under corporate laws, securities, tax laws, or otherwise. Rather, Phantom Stock is essentially a form of bonus compensation plan tied to the future profitability of the company.

If the plan is properly drafted, the granting or vesting of Phantom Stock rights should not be a taxable event, provided that no funds have been set aside to pay the bonuses. Employees only recognize income as and when they receive cash bonuses, and the employer is permitted to deduct the amount of bonuses from income. Care should be taken, however, that the plan is structured so as to avoid recognition of deferred compensation income before the bonus is paid. The employer should consult with its tax advisors in drafting the plan documents.

8. Stock Appreciation Rights (SAR’s). Like Phantom Stock, Stock Appreciation Rights (SAR’s) are not stock at all but a bonus compensation arrangement. SAR’s are similar in some respects to Stock Options. Employees have the right to receive payment of a bonus equal to the difference in the value of the company’s stock at the time the right is granted (the Grant Date) and the value of the stock at the time the right is exercised (the Exercise Date). The SAR’s plan may provide for vesting, i.e., permitting exercise of the right only after the employee has been with the company for a certain period. Employees may share in the proceeds of an eventual acquisition. SAR’s differ from Stock Options, however, in that employees are not required to pay anything when the right is exercised.

Upon exercising the right, the employee may receive a cash bonus, or shares of the employer’s stock. As with Phantom Stock, the granting or vesting of SAR’s is generally not a taxable event, if the plan is unfunded. Income is only recognized when the bonus is paid. Again, however, the employer should consult with its tax advisors in drafting the SAR’s documents in order to avoid recognition of deferred compensation income before the Exercise Date.

In summary, in order to identify the most appropriate compensation strategy, the employer should address the following questions:

(a) Should participants be granted Stock Options to purchase shares sometime in the future? Or should they receive shares now in the form of Restricted Stock which will vest sometime in the future?

(b) What class of employees will be eligible to participate? Will the equity compensation be limited to only certain employees (e.g., top management), or will equity be made available to all employees?

(c) Should Stock Options be made available only to employees, or will non-employees (e.g., independent contractors, strategic partners, etc.), to participate?

(d) How much, if anything, will employees be required to pay for their shares? Are the shares intended as a pure benefit?

(e) How long should Stock Options or Restricted Stock remain unvested? Should options or shares vest all at once, or in stages (i.e., cliff vesting)?

(f) Once Stock Options have vested, how long should employees have to exercise their options?

(g) What percentage of the total equity ownership of the company will be made available to the employees, assuming that all Stock Options have exercised or the entire pool of Restricted Stock has been issued?

(h) Is the employer committed to the concept of granting equity to employees? Or is the employer willing to consider other creative compensation strategies, such as Phantom Stock or Stock Appreciation Rights?

A final word. The most valuable resources to any business are loyal, hardworking and talented employees. Extraordinary performance should be rewarded, with bonuses based on performance and profitability. But hard work and longevity by themselves do not entitle an employee to ownership of the company. Employees should expect fair compensation in exchange for services – not equity. Before offering employees a piece of the corporate pie, think long and hard about all of the implications, and the alternatives.

About Davis, Agnor, Rapaport & Skalny, LLC
Davis, Agnor, Rapaport & Skalny, LLC, is a multi-disciplinary law firm offering a broad spectrum of legal services to businesses and individuals. The Howard County-based firm is committed to an individualized, client-driven approach to legal representation. For more information, visit www.DARSLaw.com or call our offices at (410) 995-5800.