business builder benefits
Methods vary for
granting stock
ownership to staff
by Jim Myott
The collapse of the dot-coms followed by the Enron scandal tainted the concept of using company stock as a way to retain and motivate employees. The need to attract and keep talented people in your business has not changed, however.
Stock options, employee stock ownership plans (ESOPs) and other methods of employee participation in company growth continue to be important tools for privately held companies to gain a competitive edge through increased commitment from employees.
The key ways you can share ownership or company value with all or a select group of employees include direct ownership, employee stock ownership plans, and stock value compensation plans. Let’s look at each one.
Direct ownership. The simplest way to share ownership is to grant or sell shares to key employees. It is common for a few employees of closely held businesses to own a small percentage of the outstanding shares, acquired through purchase or a stock bonus. Often these shares are nonvoting, which means the employees have no direct role in governing the company.
The advantages include allowing key employees to share in the growth of the company; requiring the employees to invest personal funds in the company (which should add incentive for company growth); and offering simple implementation.
The disadvantages include a lack of tax benefits and a potentially inaccurate reflection of the stock’s fair market value.
Employee stock ownership plans (ESOPs). An ESOP is a qualified retirement plan that owns company stock on behalf of all or most of the employees, because ESOP participation cannot be limited to a select group of employees.
An ESOP is most commonly set up to buy out the stock of a major owner due to retirement or a desire to diversify assets. Some ESOPs, however, are set up to allow the employees to become part owners, with the ESOP owning no more than 30 percent or so of the shares.
Congress has favored ESOPs over the years by granting major tax benefits as an incentive for sharing ownership with all employees. The benefits include tax deductions of the funds used by the ESOP to buy the stock, and the ability of the selling stockholder to postpone or eliminate tax on the sale (subject to many conditions).
Recently the most notable tax benefit has been the tax exemption provided to ESOPs that own stock of an S corporation. Generally, the S corporation shareholders are subject to tax on the corporate earnings; an ESOP that owns S corporation stock, however, is exempt from tax on its share of the company earnings. As with other retirement plans, employees will be taxed when they receive distributions from an ESOP, although they can postpone taxation by rolling over the funds to an IRA or another qualified plan.
ESOPs are complicated and can be expensive to operate but they are the gold standard of employee ownership. ESOPs provide many employees with significant retirement benefits due to their own efforts that helped their company grow.
Stock options. Stock options give a select group of employees the option to purchase a certain number of shares of the company at a future date at today’s price. They are most commonly used with public companies and with start-up private companies that hope to go public in the future.
Options come in two varieties: nonstatutory stock options (NSOs) and statutory incentive stock options (ISOs). In both cases the employee is normally not subject to tax when the option is granted.
In the case of an NSO, upon the exercise of an option the gain in value from the option price to the current value of the stock becomes compensation income to the employee, whether or not the employee sells the stock at that time or holds onto it.
The ISO option does not trigger taxable income. Instead, the employee is taxed when the stock is sold. There are several conditions that must be met in order for a stock option program to qualify as an ISO, including an annual limit per covered employee of $100,000 of stock that could be purchased under the option program.
Stock option programs have the advantage of granting key employees the incentive to grow the value of the stock without incurring any cost until they decide to exercise the option. While this incentive has been misused in the case of Enron, WorldCom and some other public companies, it remains a key component of compensation for many companies.
Stock value compensation programs. There are many types of compensation programs that reward employees for increases in company and stock value without directly involving stock. The most common of these are phantom stock arrangements and stock appreciation rights (SARs).
In all of these programs key employees are granted either a current bonus or deferred compensation based on the value of the stock, or the increase in value of the stock.
Under a phantom stock arrangement, the employee is granted units that are priced at the value of the stock so even if the stock value declines the employee will still receive some compensation. An SAR program only rewards the employee for increases in stock value. Deferred compensation programs that use stock value often include vesting, which means that the employee only obtains the benefits by remaining with the company for a certain number of years.
The advantages of these programs are their relative simplicity and the fact that they can provide incentive for stock value growth without actually changing the stock ownership. A key disadvantage for the employee is these programs are usually unfunded, with the benefits dependent on the solvency of the company at the time the funds are to be paid.
All these methods are frequently used as a way to provide employees with additional incentive to improve the performance and value of the company for which they work. Despite Enron and the other corporate scandals, providing employees with a stake in the value of the company remains a key motivator for obtaining maximum effort in competing and winning in the global economy.
[contact] Jim Myott, CPA, J.D., is a partner and employee benefits consultant with Boulay, Heutmaker, Zibell & Co. in Edina: 952.893.3822; jmyott@bhz.com; www.bhz.com
