I have been running a successful distribution business for several years. I have two or three very important 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 very important 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 very important 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 very important 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 US$20, that US$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 US$20, the result is exactly the same. You must report US$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 US$20. The US$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 very important 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 US$100,000, and you give an employee stock equal to one per cent of the outstanding shares, the employee will have US$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 employee to have;

. multiply the value of your company by that percentage, and make that the “purchase price” the 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 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.

– Creators News Service