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A client calls to ask how to keep a key employee who feels entitled to some form of ownership in the client's business. The client does not want to lose the employee, as this loss would have a significant negative impact on the business. It is not uncommon for clients to encounter thisissue.
Very often, a business has grown and succeeded because of the efforts of a few key employees. To reward and retain those employees, companies often look for ways to extend ownership, or the feeling of ownership, to their key people. What options are available? And what are the related advantages and disadvantages? Many factors must be considered when offering forms of ownership, and different risks and costs are associated with the various options. This discussion focuses on the path chosen by one of the authors' clients, involving the decision to offer a profits interest to an employee.
A Company LLC was in the medical services industry and was formed as a single-member limited liability company in 1997. A had been taxed as an S corporation since 2002. Its sole shareholder, B, was not a medical doctor (M.D.). Companies operating in this highly profitable sector are not required to have an M.D. on staff, but the presence of one can provide a competitive advantage. C was A's sole M.D. employee. With an M.D. on staff, A could prescribe medicines and other treatments for patients.
Like many key employees, C was not satisfied with salary and benefits alone and wanted some form of ownership interest in A. A had neither an employment agreement nor a noncompete agreement with C. Because losing C was a substantial risk to A's competitive advantage, B began evaluating his options.
The decision to offer ownership or an ownership-like compensation vehicle requires careful consideration of tax and business consequences. Business considerations include the following:
How vital is the employee to the organization's mission? Does the employee possess unique skills that would be difficult to replace?
Does this situation affect succession planning? Is this employee contemplating a future purchase of the entire company? Will the employee's presence as part of this company increase its future value or make it easier to find an interested buyer?
Will this employee make a good business partner? Does this person work well with the current owners, or are future conflicts foreseen?
How does the current ownership group feel about giving up some portion of control of the company? Would a new perspective invigorate the company?
What is the employee's position regarding paying taxes on the value of the form of ownership? Is the tax impact a potential "deal breaker" for the employee?
With these factors in mind, B and C entered into negotiations that would give C some type of ownership rights in A. Based on the company's prior performance and C's current compensation, the two settled on 30% as a fair portion of A for C. An independent business valuation was performed, finding that the fair market value (FMV) of a 30% share of A was approximately $300,000.
Analysis of the options
Many options, and the corresponding risks, were considered when evaluating this situation, including the following:
Having the employee purchase shares;
Granting shares to the employee;
Creating a phantom stock plan for the key employee;
Issuing stock appreciation rights;
Converting into a partnership and granting a capital interest; or
Converting into a partnership and granting a profits interest.
Each option is discussed in further detail below.
Having the employee purchase shares
A common way to bring in an additional owner is through the purchase of shares. Shares can be purchased from an existing owner, or the company may issue additional shares. A business valuation is generally required to determine the FMV of the corporation's shares.
If the shares are purchased from an existing shareholder, the selling shareholder recognizes gain or loss to the extent that the proceeds differ from the shareholder's basis.
If the purchase is financed with a loan, the new shareholder can deduct the interest but must allocate the interest between business interest and investment interest. The loan may be financed through a third party or by the seller. Financing the loan through a third party has the advantage of transferring risk away from the seller.
C did not have the resources to purchase shares of A. B was reluctant to finance the purchase, so this option was eliminated from consideration.
Another method to add shareholders is to grant shares. In this situation, the new shareholder would recognize income at the grant date in the amount of the FMV of the new shares. Depending on the shares' value, this could result in a sizable tax liability. Distributions of cash to the new shareholder can mitigate this; however, cash distributions must remain proportionate in an S corporation, which may mean that additional cash distributions need to be made to the existing shareholders. Cash flow issues may preclude this.
Both C and B wanted the transaction's structure to be as tax-neutral as possible for C, so this option was out.