A common decision that often arises at some stage in a private company’s growth involves whether to give key employees the opportunity for an ownership stake in the business. This matter may arise from the employees expressing an interest, or from a desire on the part of the current owners to provide additional incentive to key employees and/or set the stage for an ultimate transition of complete ownership to these employees.
There are a number of important considerations when evaluating the pros and cons of such an initiative, not the least of which involve taxes.
Employees’ taxes with respect to their employment earnings are generally reasonably straightforward. Wages are subject to withholdings, Forms W-2 are received in January, and tax filings can be relatively easy.
However, most private companies operate as some form of pass-through entity, wherein income taxes on business profits are paid by the owners, rather than by the business. When employees become owners in such a business, they can be unprepared for the higher level of complexity in tax planning and filing. Their withholding may not be sufficient to cover taxes now due, figuring out estimated tax payment requirements can be tricky, and funds availability may present issues.
Tax returns cannot be filed until the business completes its filings and generates Schedules K-1. If the business files as a partnership, an individual treated as a partner can no longer be considered an employee, potentially eliminating the historical reliance on withholdings to cover tax payment needs.
Generally, an employee can readily equate the amount of taxable wages reflected in a Form W-2 to the cash flow recognized from an employment relationship. An employee who becomes an owner may have difficulty understanding the potential material lack of a direct relationship between the amounts of income passing through from the business in a Schedule K-1 to the cash flow experienced over the related reporting period.
Complicating such circumstances can be the economic arrangements giving rise to the ownership interest; for example, repayment of debt taken on to purchase the ownership interest where distributions from the business may be limited under credit covenants or other operating requirements to only amounts sufficient to cover taxes on the pass-through of business income.
If the ownership transition will likely involve a sale to a third party, and the motivation of both employee and employer is largely to incent employees to grow the value of the enterprise for this purpose, granting employees ownership can present challenges for both sides which outweigh the benefits. In this case, an appropriately designed, implemented, and operated incentive compensation arrangement that does not involve a direct equity interest is often a better option. While the employee may have some undesirable tax consequences with this type of arrangement – for example, paying higher ordinary income rates rather than lower capital gains rates – the current and interim tax implications can be more favorable.
We invite you to contact us to discuss your goals and concerns in this regard and learn more about the options that may be best for your business.
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