To provide incentive to a key employee without depleting current cash flow, consider a form of equity sharing. There are several options for granting an equity share to a key employee. The possible types of ownership interests differ based on the form and substance of what is transferred:
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1. Full membership interest - includes voting rights and a proportionate interest in profits, losses and capital.
2. Non-voting membership interest – a proportionate interest in profits, losses and capital, without voting rights.
3. Profits interest – an interest in profits only, without an equity interest. This can include or not include participation in any ultimate sale of the company.
4. “Phantom stock” – a “theoretical” proportionate interest in the company that would accrue proportionate distributions and entitle participation in any ultimate sale of the company. Since this is not an actual legal ownership interest, amounts paid would be treated as ordinary income to the recipient and as a deduction to the company.
5. “Stock appreciation rights” – a “theoretical” proportionate interest in the increase in value of the company from the date rights are granted until a pre-determined end date or sale of the company. Since this is not an actual legal ownership interest, amounts paid would be treated as ordinary income to the recipient and as a deduction to the company.
6. Restricted shares – a proportionate ownership interest that is dependent on continued employment with the company. The recipient can make an election (within 30 days) to report the value of the interest as income upon receipt. Presumably, the value would be minimal at that time as would the tax consequences. If the interest is held for longer than one year, any ultimate gain on sale would be taxed as long term capital gain. However, if the recipient forfeits the shares, he or she would not be entitled to a refund of any taxes paid on the initial value. Alternatively, the recipient can choose not to recognize income on receipt. However, upon removal of the restrictions or sale, the entire fair market value at that time would be taxable as ordinary income. The company would be entitled to a deduction.
Any amount paid for the interest by the recipient would be treated as cost basis, offsetting ultimate gain on sale.
Factors that may influence the decision include preferences as to:
· Whether or not the employee should have unconditional ownership, earn ownership over time or ownership contingent on remaining with the company for a certain period of time.
· Whether or not the employee should have voting rights (and other rights) of a legal owner.
· Whether or not the employee will be entitled to current profit distributions or a share of ultimate sale proceeds, or both.
Before deciding on sharing equity (or advising clients on this issue), the first question to ask is, “Is equity sharing necessary to attract, motivate or retain the key employee?” If the answer is no, then the process should end there – until or unless there is a change in circumstances.
Bottom Line: The structure for transferring ownership and value should be determined based on the desired economic results. And, a qualified attorney should always be involved!