By Maurie Cashman
To retain employees with a stock bonus, use structured plan to make bonus attractive to employee and protect company. The stock bonus we will discuss in this article is different from Incentive Plans to Retain Key Employees During a Business Transfer that we discussed in a previous edition.
How does an 83(b) plan retain the employee after the ownerâ€™s departure?
When a stock bonus is used as a tool to retain key employees, the bonus is taxable when the employee has control of the stock. If there is a vesting period, the employee does not control the stock until it the vesting period has expired. At that time tax is due on the fair market value of the stock. An 83(b) election is a tax management tool in which the receiver of a stock bonus that is subject to vesting elects to be taxed at the time the bonus is received, instead of when the vesting period has lapsed. Tax is paid at time of election at normal income tax rate of the recipient. If the stock has appreciated in value when it vests, the tax due on the gain is the lower capital gains rate rather than normal income tax rates.
Letâ€™s look at an example of how this might be structured.
Tom owns a company that manufactures agricultural parts and equipment. As part of his ownership transition plan he wants to devise a plan to reward and retain Fern, his Sales Manager. In working with Tom we developed a stock bonus plan to reward her performance, give her a strong stake in the future success of the company and handcuff her to the business for the long term.
Tom grants 1000 shares subject to vesting and valued at $50.00 at the time the shares are granted to Fern. The shares will be vested over a period of five years, which means that she will receive 200 shares every year for five years. In each of the five vested years, she will have to pay tax on the fair market value of the 200 shares vested. If the value of the companyâ€™s shares increases to $100.00, then Fernâ€™s share value increases to $20,000 from $10,000. Her tax liability for year 1 will be, ($20,000 – $10,000) x 35% = $3,500. If the stock value rises to $200/share by year five her tax liability in year five will be $10,500. Fernâ€™s tax liability over five years could approach $40,000.
To make this more attractive, Tom decides to gross up the stock bonus by the amount of the tax liability when the stock is granted and Fern agrees to sign an 83(b) election. Tom pays a cash bonus of $17,500 to Fern which is enough to cover the tax due on the stock grant (1,000 x $50.00 x35% = $17,500). Tom pays the tax, which is deductible by the company when the grant is made. Fern signs an agreement containing a clause that if she leaves the company before the stock has vested, she will forfeit the stock and will repay the $17,500 cash bonus. There is also a buy-sell agreement stating that Fern must sell her stock to the company if she leaves at any time after the shares have vested.
Fern is now in a position to hold her stock indefinitely with no additional tax until she sells. If shares are sold for a profit at a later year, Fern will be subject to a capital gains tax on her gain from the proceeds of the sale, which will be a much lower rate than the normal income tax rate she would have paid at grant.
Significant taxes were saved between Fern and Tom by structuring the bonus in this manner. Fern has a very strong incentive to increase the value of the company since the only taxes she would owe on the increase in her share value is for capital gains. Tom has Fern handcuffed to the firm by virtue of the long term financial gain Fern stands to gain if she stays with the company.
With proper planning and experienced advice you may be able to structure a attractive stock bonus plan to retain key employees to protect the value of your company.
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