Giving Ownership to a Key Employee

Many business owners tell me that they would like to give a piece of their company to a key employee. They think that will bind that employee further to the business by their loyalty and hope that that key employee never leaves them and puts them in a bind or puts their business at risk. Now, on the surface this may sound like a fantastic idea because it feels like it doesn't cost you a whole lot of money. But I'm here to tell you this is one of those areas that you don't want to do. Okay? There are many reasons why this could be a terrible disaster for your business. So let's talk about those for a moment. First off, depending on how your entity is structured, and I'm going to make some generalizations here today, I'll forewarn you talk with your cpa, your advisors, and make sure that your situation is the same as what I'm talking about. But in general, giving away a piece of your business will bind you from being able to make the decisions that you otherwise would have. So for example, retirement plans, health insurance plans, any types of plans that might be part of your tax strategies that that are geared towards helping the owner save some money or have some extra benefits will be dramatically affected. Because now you have to please that other owner of the business with no matter how big or how small, it will have a dramatic effect on what you can do from a retirement plan standpoint or a health insurance or any other kinds of employee benefits. Okay, that is point one. Point two. Often when I hear people say, well, if I just gave them a 5% interest in the business, it's not really going to hurt me. That's not that much income. However, keep in mind that if yours is a flow through entity like most small businesses now, your employee has to pay taxes on that 5% earnings of the business. What happens if your business gets stuck in a lawsuit? Guess what, your employee's on the hook too. They are an owner of the business, so they could be held liable as well. They probably don't want those concerns. Many business owners think, well, I own a business so everybody should want to do this. Many of your employees just don't want or don't understand the complexities of being a business owner. They may love working for your business and being a key person in the decision making with you, but the headaches of owning a business are pretty drastic when it comes to the complexities of paying taxes. Also, being an owner can create additional liability that they don't want. So looking also at distributions. So when you as an owner Decide you want to take money out of the business, the business is doing well. Typically you may have a payroll component, but but you'll also have a shareholder distribution component. Guess what? Those have to be in proportion to ownership. So if you decide today that you want to take out $50,000 because you want to buy a new car, go on a great vacation, or put some improvements into your house, you now have to give your employee a proportional sized benefit distribution wise, just like you would take. So that may not have been what you really expected. So let's talk about two ways that you can deal with this theory of having your employee have a bigger stake in the company and getting some more long term loyalty out of them without having to give up selling a piece of your business to them or giving a piece of your business to them, which is by the way a taxable event if you give it to them and don't charge them the fair market value. All right, so ways that you can do this without giving up a piece of your business. One way that's pretty easy is to look at your 401k plan or your retirement plan. Perhaps you could set up a vesting schedule where you are feeding more money in to the 401k plan as a benefit to your employee, but they have to stick around to get it. Many cases they have five year vesting plans on 401ks where you may earn, let's say you put $10,000 in there for their employer or contribution to your 401k. If they stick around after year one, they get 20% of that. If they stick around after year two, you get 40% ratcheting on up to 100%. After five years you've bought some loyalty time. If they leave before that time frame of their vesting schedule is up, those funds are forfeited and will most likely go back to benefiting the owner of the company and the other participants in the plan. So not a bad downside. If they did happen to leave, obviously we want them to stay. The second way to do this is through a joint venture. Joint venture is a contractual obligation between two businesses. So have your employee form a business if this is part of what you want to do, and have a contractual obligation that you will pay that employee or that employee's business X number of dollars when something happens, or at the end of the year or on a periodic time schedule. And you can also set up exit provisions. What happens if one of you wants out? What if you want to terminate the agreement? Then it has no real effect it doesn't run your business into the ground. Having to deal with a former employee who now owns your company. And you can't just get rid of them. Alright, so look at some alternative strategies if you think that you want to give a piece of your business away to a key employee. It is really a pretty drastic measure and I don't often see a good solid reason to do it. It creates a lot of complexity and rarely does it do what you expected it to do. But there are other ways to work around that, and as your advisor in a CPA role, that is one of the things I do. I will help you brainstorm to determine the best way to deal with that situation, to put as little at risk for you as possible, but still provide the benefit that you want to to that key employee. SA.