Flexible ownership incentives for key employees

Editor: Michael D. Koppel, CPA/PFS/CITP

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 this issue.

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.

Background

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.

Key considerations

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.

Granting shares

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.

Creating a phantom stock plan

Under a phantom stock plan, the employer awards bonuses to the key employee by providing “phantom” shares of corporate stock. The employer promises to make the employee a cash bonus payment in the future, based on the number of phantom shares granted and the value of shares of the company stock or the increase in the value of the shares over a specified period. The employee pays no tax when these phantom stock shares are granted. However, payments on the phantom units are treated as compensation to the employee.

While such a plan has many positive aspects, some of the negatives that would have resulted from a decision to use phantom stock in this case included the following: (1) The employee would not receive actual ownership in the company; and (2) the compensation would be taxed as ordinary income, versus capital gain treatment for a true ownership interest.

C wanted a true ownership interest in A, so this option was rejected.

Issuing stock appreciation rights

Stock appreciation rights (SARs) allow an employee to participate in the growth of the stock price, generally by paying the employee cash for the increase in the value of a certain number of shares of company stock over a predetermined period or at the time the employee exercises his or her rights under the plan. The payment would equal the stock’s current value less the stock value at the time of the grant. SARs are somewhat similar to phantom stock plans, except that phantom stock plans usually take into account stock splits and stock dividends, and under phantom stock plans the payment period is usually fixed.

Under a SARs plan, a bonus payment may be made in actual shares of company stock. However, as with phantom stock, the initial grant of SARs does not convey actual ownership, which was a critical requirement in this particular situation. Also, shares must be valued more frequently when an employer issues SARs, creating a significant added expense for a smaller business.

As was the case with phantom stock, C’s desire for true ownership eliminated this option. However, for many companies, SARs or phantom stock can be an ideal way to offer incentive-based compensation for key employees.

Liquidating the S corp. and reforming as a partnership

With the possible options that would have retained S corporation status off the table, the colleagues began to evaluate converting the company to a partnership. Liquidating the S corporation would result in a taxable gain for B. This would also potentially result in a higher tax liability for B on the passthrough income. As active members of the LLC, both B and C would now pay self-employment tax on any guaranteed payments plus their distributive shares of partnership income.

However, the increased flexibility of a partnership appealed to both. Distributions were no longer required to be pro rata; they would be tax-free to the extent of basis.

Purchasing shares in the partnership

Partnership shares can be purchased either from an existing partner or from the partnership in exchange for a capital contribution. As above, purchasing shares was not an option forC.

Granting a capital interest in the partnership

Granting C a capital interest in A would create a taxable transaction to C (Regs. Sec. 1.721-1(b)(1)). C would be required to recognize income in the amount of the FMV of the shares he would receive, which would have been approximately $300,000. Both C and B wanted to avoid this outcome.

Granting a future profits interest

With a profits interest, C would share in the prospective growth and income of the business. According to Rev. Proc. 93-27 and Rev. Proc. 2001-43, receipt of a pure profits interest by a service provider is not a taxable event, provided these criteria are met:

1. The partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant, and the service provider takes into account the distributive share of partnership income, gain, loss, deduction, and credit associated with that interest in computing the service provider’s income tax liability for the entire period during which the service provider has the interest;

2. Upon the grant of the interest or at the time that the interest becomes substantially vested, neither the partnership nor any of the partners deduct any amount (as wages, compensation, or otherwise) for the FMV of the interest; and

3. All other conditions of Rev. Proc. 93-27 are satisfied:

• The profits interest does not relate to a substantially certain and predictable stream of income from partnership assets.
• The partner does not dispose of the profits interest within two years of its receipt.
• The profits interest is not a limited partnership interest in a publicly traded partnership.

If all these criteria are met, Rev. Proc. 2001-43 states that a Sec. 83(b) election is unnecessary.

After several years of negotiation, B and C settled on a 30% interest in A’s future profits, with preferential rights to B in the net proceeds from any future liquidation ofA.

Converting into a partnership

Under the check-the-box regulations, if an eligible entity that has elected to be treated as an association taxed as a corporation then makes an election on Form 8832, Entity Classification Election, to change its classification to that of a partnership, Regs. Secs. 301.7701-3(g)(1)(ii) and (iii) expressly provide that the “assets up” treatment applies.

Under the assets-up approach, the corporation will be treated as first liquidating by distributing all of its assets, subject to its liabilities, to its shareholders. The second step would be to transfer the assets the shareholders received from the corporation to the partnership (or the LLC taxed as a partnership) in exchange for partnership interests.

The liquidation of the assets is treated as if the assets were sold at FMV. Gain or loss is computed by subtracting adjusted basis from the FMV amount. In the case of fixed assets whose FMV exceeds adjusted basis, depreciation recapture rules apply.

Example: A business has an FMV of $1 million with existing shareholder basis of $200,000. The gain on the deemed liquidation would be $800,000 ($1,000,000 – $200,000), and the tax on the gain, at the estimated rate of 25%, would be $200,000.

Is the tax liability incurred a worthwhile cost for the existing shareholders in exchange for retaining a key employee? The answer depends on the circumstances of every business. The immediate cash drain is substantial in this example. However, the existing shareholder will then also have a higher basis and capital account in the new partnership. Higher basis will result in less gain for the existing shareholder in the event of a sale in the future.

Goodwill

A particularly challenging issue regarding a conversion and liquidation is goodwill. As a medical practice, the LLC had a limited amount of fixed assets and other tangible assets. The assets are not the primary means of creating revenue in a service organization. It may be argued that goodwill is also an asset of the business.

However, the facts indicate that any goodwill in this liquidation cannot be an asset of the business. Goodwill is an asset of the business when the owners are not active participants in the business and are merely investors, and when none of the shareholders are critical to the company’s continued success.

In contrast, personal goodwill is an asset of the shareholders when it is their reputation, expertise, and knowledge that drive the business’s overall profit and value. If a shareholder’s departure would diminish the company’s value and its ability to continue to produce profits, the goodwill must be personal and not an asset of the company. Further, recent court cases have found that in the absence of binding noncompetition agreements, personal goodwill may exist separately from business goodwill (see, e.g., Bross Trucking, Inc., T.C. Memo. 2014-107).

B did not have a noncompetition agreement with A. As A’s sole shareholder and CEO, he was not a passive investor, and A’s long-term success and reputation were largely due to his vision and efforts. His departure would have been catastrophic and likely would have resulted in the enterprise’s complete collapse.

C also had neither an employment agreement nor a noncompetition agreement with A. While the presence of C on the staff is a competitive advantage, his departure would not be catastrophic, due in part to the unique nature of this medical service provider. A’s patients do not typically return for regular visits once they have been diagnosed and a satisfactory treatment regimen is in place. The patients’ loyalties and their satisfaction with treatment is largely due to the caring environment that B has created, not to a particular provider.

In this situation, the existence of personal goodwill owned by B reduced the gain he recognized upon the S corporation’s liquidation.

End result

Immediately upon A’s liquidation as an S corporation, it reformed as a partnership. B recognized a gain on his personal tax return for the deemed sale of A’s fixed assets and other tangible property. B contributed these assets to the new partnership. C was granted a 30% profits interest and did not incur any immediate tax liability. To compensate for B’s taxable gain on the liquidation of the S corporation, he received additional cash distributions to alleviate that burden.

The newly formed partnership has been a success. B considers the additional tax liability he incurred as the cost of retaining C a worthwhile expense, due in part to the increases in both overall revenue and net profits that have followed.

EditorNotes

Michael D. Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.