If you’re a pest management business owner who has one or more long-term key employees who wants to own equity in the business, but doesn’t expect to have to pay the fair market value for such an award, be mindful of the taxable consequences.
For example, if a pest management corporation is worth $5 million (a fact to be determined) and the sole shareholder issues new shares of stock equal to 2 percent of the business to the general manager, this transaction is viewed as a corporation issuing an employee a taxable cash bonus of $100,000. This compensation is subject to Federal Insurance Contributions Act (FICA) taxes and income taxes, just like wages reported on an IRS Form W-2.
This is a horrible result for the employee. In most instances, the employee is unable to pay the taxes and looks to the owner to solve the problem. The owner might think he or she is giving the employee a gift and therefore shouldn’t incur adverse tax results on that employee. Unfortunately, when there’s an employer-employee relationship, the IRS says it’s not a gift when an employer gives equity at zero cost or bargain price (that is, less than the true value of the stock).
In addition, if the owner didn’t pay for a professional appraiser to value the business, the IRS could allege the value of the business is higher, making the tax problem even worse than before.
The right way to do it
What can an employer do to avoid this pitfall? There are two options:
1. Sell the stock to the employee at market price, but in lieu of the employee writing a check, a promissory note is issued to the employer, promising to pay the amount over time with interest. The employer can then forgive a portion of the debt each year. Although it’s added to the employee’s W-2 each year, the employer can subsidize the tax bite, which will be at a lower marginal tax rate than if the entire value is taxable in one year — and thus artificially push the employee into a higher marginal tax bracket for the year of the award.
2. The employee receives a contractual cash-only award known as “phantom equity.” Depending on the type of legal entity involved, these awards are sometimes called phantom stock, phantom units or similar names to indicate that real stock or membership units are not involved. Phantom equity has the same economic value as owning real equity in a company, but the tax bite to the employee is deferred until the company is sold and proceeds are delivered to the employee, at which time he or she can afford to pay the taxes on the equity originally awarded.
John P. Corrigan, Esq., Hall of Famer Norm Cooper and Daniel S. Gordon, CPA, comprise the PCO M&A and Succession Specialists practice at PCO Bookkeepers. For more information, email firstname.lastname@example.org or visit PCOSuccessionPlan.com.