LUTZ BUSINESS INSIGHTS
TRANSFERRING STOCK OWNERSHIP TO NON-FAMILY EMPLOYEES & UNRELATED THIRD PARTIES
STEVE KENNEY, TAX SHAREHOLDER
In the first part of this blog series, we discussed the ins and outs of transferring stock ownership to family members. This blog, part two, will focus on transferring stock ownership to non-family employees, unrelated third parties, as well as the advantages and disadvantages of employee stock ownership plans.
WHY TRANSFER OWNERSHIP?
Why do people transfer ownership of their company stock? It could be due to a transition of management; a tactic to attract, motivate, and retain key employees; or for liquidity purposes. Whatever the reason, if you are considering transferring stock to an employee, make sure you understand your options to secure an approach that works best for you.
STOCK GRANTS OR STOCK PURCHASES
It is imperative you know the value of your business before considering an approach to transferring stock. Transfers to non-family employees can be made through stock grants and purchases. Stock grants are made when a company compensates an employee, fully or partially, in the form of corporate stock. They are taxable to the employee and are deducted by the company. Stock purchases allow employees to buy shares of the company. They are taxable to the seller. It is common to have vesting periods in the range of 3-5 years for stock grants and purchases.
Stock options provide an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. The price at which the option is provided is called the “grant” or “strike” price and is usually the market price at the time the options are granted. There are two types of stock options – nonqualified stock options (NSO) and incentive stock options (ISO). NSO’s are more common; when the employee exercises the stock option, they have ordinary income reported as wages equal to the difference between the strike price and the fair market value at the time of exercise and the Company receives a corresponding tax deduction for compensation. ISOs are less common and more restrictive, but the in contrast to the NSOs, the employee generally is not taxed upon exercise and the Company does not receive a tax deduction.
PHANTOM STOCK AND STOCK APPRECIATION RIGHTS
Phantom stock and stock appreciation rights (SARS) are cash deferred bonus plans based on the value of the company’s stock. SARS are based on an increase in value, while Phantoms are based on the value of shares. These plans create less risk for employees because there is no purchase required, however, they have ordinary income instead of capital gains. Usually, these plans are paid in cash, but can also be paid out in stock.
EMPLOYEE STOCK PURCHASE PLANS (ESPP)
Employee stock purchase plans (ESPP) are not very common in small businesses. They allow for employees to purchase company stock at a discount up to 15% discount (no more than $25,000 annually).
EMPLOYEE STOCK OWNERSHIP PLANS (ESOP)
An employee stock ownership plan (ESOP) is a tax-exempt retirement plan that borrows money from a bank/shareholder to purchase stock from another shareholder. A 401k plan is often merged with an ESOP to provide the equity needed in order to borrow.
Advantages: If the company is a C Corporation, and the shareholder sells more than 30% of the total stock, the proceeds can be reinvested and tax-deferred. A C Corp can convert into an S Corp after sale where the ESOP can own either all or a portion of the corporation. Loan payments associated with this plan are tax deductible. At retirement, ESOP participants can roll their benefit over to a self-directed IRA.
Disadvantages: A disadvantage associated with ESOPs is that they require additional costs and compliance for audit and valuation. ESOP valuation for a selling shareholder may be less than for a strategic buyer. In addition, ESOP participants generally cannot receive capital gains treatment upon sale/retirement.
SALE TO UNRELATED THIRD PARTIES
The current market for sales to unrelated third parties is HOT. Valuations are high with excess cash sitting on the sidelines. Three types of these sales include:
- Private sale
- Private equity
- Partial vs. complete sale
In conclusion, knowing your businesses valuation before participating in stock transfers to an employee is a crucial first step. The type of approach you use will depend on your business, as each one has different needs. For any questions or further discussion please contact a Lutz representative at firstname.lastname@example.org or 402.496.8800.
ABOUT THE AUTHOR
STEVE KENNEY + TAX SHAREHOLDER
Steve Kenney is a Tax Shareholder at Lutz with over 20 years of experience in taxation. He specializes in executive tax, estate, and family wealth planning, and assists with mergers and acquisitions.
AREAS OF FOCUS
AFFILIATIONS AND CREDENTIALS
- American Insititute of Certified Public Accountants, Member
- Nebraska Society of Certified Public Accountants, Member
- Omaha Estate Planning Council, Board Member
- Certified Public Accountant
- Chartered Advisor in Philanthropy
- BSBA in Finance and Accounting, Creighton University, Omaha, NE
- Children's Scholarship Fund of Omaha, Board Member, Finance Chairman
- Creighton Preparatory School, Finance Committee
- Creighton University Heider College of Business, Advisory Board
- Duchesne Academy of the Sacred Heart, Board of Trustees
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