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Five Questions to Ask Before Offering an Employee an Interest in Your Company

By Alan Becker

Business is booming! Revenues are up. Costs are in check. You’re happy with the way things are going, but you know that a big part of your success is due to your faithful, right-hand employee. Maybe it’s time to offer him or her stake in the company. It will give the employee an incentive to work even harder and might even be the start of a succession plan. And it ought to be easy – just transfer a little stock or an LLC interest and move on with one more owner.

But wait! Things are rarely as easy as they seem. There are at least five questions you should ask yourself and your lawyer before you bring that employee into the business as an owner.

Are my organizational documents ready to take on a new owner?

Most small businesses are created with fairly basic organizational documents. Your articles of incorporation and bylaws or LLC operating agreement may have been forms you got from the Secretary of State or from a website. Even if you used a lawyer to prepare the documents, the lawyer probably put them together based on your circumstances at the time. If you have been the only owner, your documents may not deal with how decisions are to be made or profits are to be divided when there are multiple owners. More importantly, they may not say what happens if one of the owners dies, becomes disabled or gets sued. Even if the business has had multiple owners, if the owners were family members, or even good friends, there may be situations that were just not relevant until someone who is not part of the family or not a good friend becomes an owner as well.

Before you bring in a new owner, you need to take a hard look at your documents and think about all of the things that could go wrong even if you and the new employee-owner have the best of intentions. Perhaps those documents need some changes, or maybe you need a new document such as a shareholders’ agreement to plan for unexpected events or to regulate how certain decisions will be made. This all needs to be done before the new owner receives an interest in the company because it will be much harder to do after the fact.

Am I ready for someone new in the “inner circle” of ownership?

Many business owners are much more willing to share profits with a valued employee than they are to share information or decision-making authority. It is not uncommon for a business owner to say a new employee-owner is welcome to a percentage of net income, but please do not ask to see the accounting records or bank statements. And if you are used to making decisions individually or as part of a small group, the idea that notices of decisions to be made must be sent to the new employee-owner could be shocking. The law presumes that any owner of a business, whether a majority owner or a minority owner, is entitled to certain specific rights such as access to business records and information and notices of meetings and upcoming decisions, as well as more general rights to be treated fairly and with good faith. It is possible to limit some of these rights in the company’s organizational documents or by separate agreement, but in most cases this needs to be done before the employee is made an owner rather than later.

Will my employee owe income taxes as a result of receiving the ownership interest?

Your business has value, and an ownership interest in it does too. If you gave your valued employee ownership of a car, the federal and state tax laws would treat the value of that car as compensation, and the employee would need to pay income tax on it. The same thing is true with an ownership interest in your business. Simply handing shares of stock or an LLC interest over to the employee generally means the employee will owe income taxes on the value of that interest unless you transfer the interest correctly. Even worse, if you transfer part of your own ownership stake for free to the employee, you and the employee may both owe income taxes on the transfer!

Fortunately, the tax laws offer some strategies that can allow you to give an employee an ownership interest without immediate income tax consequences. Generally these strategies are based on making the ownership interest have a zero value today so there is no tax due. After all, what you are probably trying to achieve is motivating the employee by offering a chance to share in future increases in the value of the business. Handing over a piece of the current value of the business may not need to be part of the deal.

These tax strategies are not hard to accomplish, but it is not always obvious how to set them up. This is a case when a little help from a lawyer can be invaluable.

What should I say about how this will change my employee’s annual income taxes?

Most people who do not own a small business are not familiar with the concept of paying income taxes on a portion of the income of the business rather than on just the cash they receive from the business. In particular, they may not realize that they must pay income taxes on the company’s income even if the company has no cash available to distribute to them. Whether your company is organized as an S corporation, an LLC or a partnership, that is precisely the situation your employee-owner will be in. Moreover, while it is possible to set up the ownership interest in some cases so the employee continues to receive something that looks like a fixed “salary” rather than a percentage of the profits, even then the employee’s income tax return will be more complicated than in the days when the employee just received a W-2.

This is not an issue that should deter an employee from accepting a stake in your company, but in many cases it will be a surprise. Simple fairness (and maybe the disclosure requirements under federal and state securities laws) demands that you help your employee understand how becoming an owner of the company will change his or her tax situation.

Can I do this without violating the securities laws?

Under federal and state securities laws, “selling” an interest in your company to an employee involves the sale of a security that requires you to comply with registration and disclosure rules. While it may not seem like you are selling anything to the employee because the employee is not writing you a check, the law is clear that an employee who receives an interest in a company as a benefit, even for free, is buying the interest with the employee’s labor. Fortunately, the securities laws provide a number of exemptions from the registration requirements for sales of company interests to employees such as this. Some of them require following certain rules, but it is likely that a path can be found for you to give your employee an interest in the company without involvement by the SEC or state securities officials. If you ignore these requirements, however, you (yes, you and not just your company) are personally guaranteeing that the employee will make money on the ownership interest.

The securities laws also require that you provide your employee with the material facts about the company before you issue the ownership interest. In other words, you must tell the employee information about the company that a reasonable person would want to know before investing in the company. Again, while it may seem unnecessary to provide this information when the employee is getting the company interest for free, you must remember that the law sees the employee as committing future efforts to the company in exchange for the ownership interest, which is treated the same as if the employee were paying cash. It is a good idea to document what information you give your employee so that there is less chance of faulty memories or “you never told me that” later.

Dealing with the Answers

Once you have answered these five questions, then you may have some work to do before transferring an ownership interest to your employee. If you need to make changes to your organizational documents to accommodate an additional owner, attorneys from Bose McKinney & Evans have developed provisions with a track-record of positive implementation. While you are making changes, you can take the opportunity to fine tune the information access and governance rights of minority owners, if needed. Your lawyer also can help design the transfer of the ownership interest in a way that minimizes any immediate tax effects on you or your employee as well as advise on proper disclosure of tax and business information before the transfer occurs.

Giving a trusted employee an ownership stake in your business can be a great way to provide motivation and accelerate growth for the future. It can also be the beginning of a process that assures your business will go on after you have decided to kick back and finally take life easier. A little planning before you share your ownership, however, can save both you and the new employee-owner some unpleasant surprises.