Minimizing owner taxes is always an important component of Ownership Transition Planning, but when using stock bonuses, we also consider the key employee’s taxes.
In “Stock Bonus Plans Have Many Advantages†we met Adam Norton, the 54-year-old owner of Norton Glass, a manufacturer of commercial greenhouses. He told us that he wanted to:
- Transfer his company to a group of his key employees;
- Make this transfer over the next five to ten years.
After we confirmed that Adam’s Key Employee Group was indeed willing and able to assume leadership, we suggested a Stock Bonus Plan.
At first glance a stock bonus seems like a risk-free reward to key employees. Once employees understand all the details, however, they are likely to say, “Thanks, but no thanks. I can’t afford it.†In fact, the greater the value of the awarded stock, the more problematic the bonus becomes! How can that be? The key employee receives ownership without paying for it, but that value is taxable income to the employee. Key employees must pay that tax with their own money.
Minimizing owner taxes is always an important component of Ownership Transition Planning, but when using stock bonuses, we also consider the key employee’s taxes.
Adam had no desire to help employees pay the tax on their bonuses. He changed his opinion, however, after we added the following features to the stock and cash bonus plan:
- The Gross-Up Strategy
- Forfeiture
- Section 83(b) Election
We’ll discuss the gross-up strategy in this article and forfeiture and the 83(b) election in the next.
The Gross-Up Strategy
Here is an example of the Gross-Up Strategy:
If the Fair Market Value of a stock bonus is $40,000, Adam’s company receives a $40,000 tax deduction, and the employee has taxable income of $40,000. Assuming a 30% tax rate, the employee owes about $12,000 in taxes. Using the gross-up strategy we simply calculate the additional cash bonus required to pay the taxes on both the stock bonus and the initial cash bonus. In this example, Adam would award a cash bonus of about $16,000 to the employee to pay the taxes on both the $40,000 stock bonus and the $16,000 cash bonus.
Using this strategy, there is usually little or no net out-of-pocket cost to a company. Having bonused the key employee $16,000 in cash and $40,000 in stock, the company takes a tax deduction of $56,000. In the company’s 21% tax bracket, the deduction reduces the company’s taxes by $12,000—nearly a wash in terms of cash flow as the company pays a $16,000 bonus but has a $12,000 tax saving.
Of course, a key employee can quit immediately after receiving the stock and cash bonus. The company is then forced to re-purchase the bonused stock for $40,000. This after-tax amount requires about $50,000 of pre-tax cash. How can you protect yourself?
We recommend Stock and Cash Bonus Plans that incorporate forfeiture provisions. We’ll talk about that next time.