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The question of employee equity comes up regularly in small business environments. Employees may believe that having a “stake” in the business will validate their importance, enhance their sense of accomplishment and self-worth.  Employees may also believe (rightly or wrongly) that ownership will provide a significant financial upside.  Offering equity to employees can be attractive to a small business as well.  This is particularly true for start-ups which are not able to match the salary and benefits offered by established competitors—for these businesses, offering an employee some equity may seem like a good way to attract affordable, talented employees and to motivate them by having “skin in the game”.

True equity consists of an ownership stake in the company itself: i.e., shares of a corporation’s stock, a membership interest in an LLC, or a partnership interest in a partnership.  An employee can acquire equity in one of two ways:

  1. By buying equity. This is typically done either by exercising a stock option or by simply purchasing shares at an agreed price.
  2. By receiving equity as a bonus (i.e., without charge), either as a one-time stock bonus or (more commonly) under a restricted stock plan with performance milestones and vesting.

From an employee’s perspective, neither of these is ideal.  Option 1 involves writing a check to the employer.  Option 2 involves writing a check to the IRS.  This may come as an unwelcome surprise to the employee.  But, to the IRS, a stock bonus is simply another form of taxable compensation, and the employee will be required to pay tax on the fair market value of the equity bonused by the employer.

The employee may be in for another surprise.  If the employer (like many small businesses) is taxed as a partnership or as an S-Corporation, the employer itself will pay very little income tax.  Instead, the employer’s taxable income is reported by its owners on their personal tax returns, and the resulting tax is paid by the owners, even if the employer fails to make any financial distributions to its owners.

Granting equity to a key employee can bring unintended consequences to the employer as well.  First, as an equity holder, the employee will typically have voting rights.  He or she will also have the right to inspect the financial records of the employer, and therefore will know how much money the corporation is making, and where it is being spent.  The employee will also have the right to inspect the employer’s legal documents, such as its bylaws or operating agreement.  Finally, the majority shareholders will now owe fiduciary duties to the employee.  If there is a falling out, the employer could be stuck with disgruntled former employee who has access to inside information and is in a position to question management’s every move.

So, what is to be done?  We will review some potential solutions and alternatives in the next installment.

This is a general overview and not to be confused as legal advice. If you would like to speak to Jonathan about estate planning, legal, business or tax matter, please email him at jcw@eastbaybusinesslawyer.com or call him at (925) 217-3255.

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