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Vesting and Expanding Ownership
By Jason Watson, CPA
Posted Sunday, July 11, 2021
You, or someone you know, might have had a job where the company-match to your 401k was vested over time or the business had a restricted stock grant that only triggered after so many years of service. For most of our readers this concern is moot since the idea of expanding ownership is not on the radar. However, life is funny, and you never know how your path might change directions with left turns at right angles.
If the transfer of stock and subsequent ownership is not handled correctly within your S corporation, this could be considered a second class of voting stock which nullifies the S Corp election. Therefore, if you are contemplating bringing in other owners or partners please read on. If you are not considering it, please read anyway so you have some basic knowledge of the problems.
If you have a successful S Corp and you sell 10% of your stock to a key employee, you suddenly create a zillion headaches. First, what is the valuation of the stock? A valuation too low might be considered compensatory triggering an income tax obligation for the employee buyer.
What is the cost basis of the shares? This is arguably easier since we would just look at your shareholder basis to determine the capital gain (if any). However, many business owners freak out when they are faced with a capital gain when selling a minority interest in the business.
For example, WCG has a client who established a value of his business based on a long calculus. His basic argument was that he injected intellectual property into the business and therefore his shareholder basis was $250,000. Look at the big brain on Brad! No doubt, this guy was smart and his business was probably worth $250,000 from the beginning. However, he neglected some accounting basics and IRS law.
In its simplest form, you cannot create basis in a business without paying income taxes on the money used to establish the basis. Huh? Let’s say you have $1,000 in your pocket. You paid income taxes on that $1,000. You buy stock for $1,000 and sell it for $1,500. Your basis is $1,000 and your gain is $500. Piece of cake.
Same with a business. You wrote a check for $250,000 and you paid income taxes on that money. When you sell your business for $400,000 you will have a $150,000 gain because the $250,000 was already taxed.
Therefore, you cannot create basis out of thin air. In the case of intellectual property, the owner would have had to pick up $250,000 worth of income on his individual tax return somewhere in the past in order to have $250,000 of basis in his business. Same with a loan. If the bank gives you a loan, either through the business or through you personally, the principal payments are not tax deductible since it is essentially a return of capital. As such, if the personal loan is your injection to create basis in your business, it too is done with after-tax dollars.
Another way to look at this is your personal home. You borrow $300,000 to buy a $300,000 house. Over the course of 30 years you paid over $500,000 in total payments but when you sell the house, your basis remains at $300,000 (and hopefully the $200,000 in interest was tax deductible).
Does this make sense? No? Crud. Perhaps have a nice Dale’s Pale Ale and give us a call. We can try walking through it another way. We might need a Dale’s too! Yum.
Back to the headaches of selling 10% of your business to someone else. This 10% owner now gets a K-1 with 10% of the S Corp’s net business income as taxable income. All shareholder distributions must be allocated among all shareholders. So, if you want to pull out $9,000 to pay for your family vacation, you also need to write a $1,000 check to your new 10% shareholder buddy. Cancel the flights. You might have to drive to vacation.
Death, divorce and incapacitation. Does your Operating Agreement (LLC) or Shareholder Agreement (C Corp or Professional Corp) deal with death, divorce or incapacitation? You need to. What is incapacitation? Do you need two doctors to sign off? If the remaining shareholders have first right of refusal on the re-purchase of the crazy man’s stock, how is that valued? It will be hard to negotiate in good faith with someone who is incapacitated.
We touch on various other traps and pitfalls in an earlier chapter when expanding ownership.
Speaking of value, 10% of the shares issued to the new shareholder have very little value. Since the S corporation is closely held, there is not a market to establish the value of the shares. A bank would probably not use the shares as collateral. The majority shareholder (you, in this string of examples) could run the business into the ground or simply shut the business down. The 10% shareholder has very little recourse outside of dissenting shareholder lawsuits (unless there is some contractual obligation governing these possibilities).
Lastly, the 10% shareholder might want to be involved with daily decisions or long-term decisions. Sure, the majority doesn’t technically have to listen or even care, but that isn’t the most professional way to foster the new relationship. Office politics suddenly become a reality in a business in which you never had to consider it. Want to buy a business car? Might have to get permission. Yuck.
So, what can you do? You have several options to bring in new owners without creating immediate problems, and you can get creative.
Employee Stock Ownership Plan (ESOP)
We mentioned this in an earlier chapter but we expand a bit to illustrate the challenges of expanding ownership and offer ESOPs as a solution for your S corporation. ESOPs are a great way to reward and incentivize employees. They also create a market for the shares of a departing owner or an owner who wants to expand ownership to the employees. Remember, if you have a growing business and you want to start working on an exit strategy or transition plan, using your own staff as future suitors might be the best idea. They have been vetted over time and know the business very well.
Here are the basics of an ESOP. A business creates a trust where shares or cash to buy shares are contributed to the trust account. Each share is allocated to individual employee accounts. You can discriminate based on years of service, full-time versus part-time and age. There are rules on this of course. The default is 1,000 hours of service in a plan year and 21 years old.
You can also create vesting schedules. For cliff vesting where the employee has either 0% or 100%, the maximum vesting schedule is three years. And for graded vesting schedules, the maximum is six years. This is because an ESOP is a qualified defined contribution plan and must follow the rules.
Here is a sample schedule-
|3-Year Cliff Schedule||6-Year Graded Schedule|
|Year||Vested %||Year||Vested %|
You can find vesting rules in IRC Section 411(a)(2)(B).
Here are some other takeaways on ESOPs. The percentage of ownership held by the ESOP of an S corporation is tax-deferred. For example, the S Corp earns $500,000 and the ESOP owns 40%. $200,000 of the taxable income should be added to the ESOP and allocated to each employee participant. This is a tax deferral not a tax deduction. When the employee sells or withdraws the shares (such as retirement) there will be a taxable event based on the individual’s tax rate.
This makes sense since an S corporation is a pass-through entity. So if an ESOP trust owns a portion of the stock, the beneficiaries of the trust (employees) will have a deferred tax obligation.
As an aside, a common theme in income taxation is one person’s deduction is another person’s taxable income (mortgage interest is a great example). A great exception is charitable donations- your deduction is not a taxable gain to the charity. Back to the ESOP- if a business may deduct the cash or stock contribution into an ESOP, the taxable income is later picked up by the ESOP participants when the money is taken out.
Here are some more takeaways. The law currently does not allow ESOPs for partnerships or professional corporations. Departing employees’ shares must be re-purchased. Costs of these plans can be substantial (as much as $40,000 depending on complexity, according to the National Center of Employee Ownership).
If you are seriously considering this please review Section 401(a) of the Internal Revenue Code in between P90X reps at the gym, contact the NCEO (www.nceo.org) or contact us.
Here is quick link to NCEO’s article-
Hybrid Purchase Schemes
If the ESOP doesn’t suit your needs and if you are afraid of introducing additional ownership through a simple stock sale, the sky is the limit on creating your own scheme. Time to put your thinking cap on.
Again, this is under the auspice of the problems of having an S corporation and wanting to expand ownership. Expanding ownership in a multi-member LLC does not have the same problems with distributions and allocations as an S Corp.
WCG recently consulted on a buy-in scheme involving several millions of dollars. A trust was created and funded with profit incentives. In approximately ten years, if profit goals were achieved, the trust would be fully funded, and a partnership would come to life. The funds would be directed by the trust and trustee to purchase a large chunk of the business for the benefit of the new LLC.
Initially the attorneys involved had an arrangement set up where three key employees would eventually be the members of the LLC (in other words, partners in a partnership). However, it was suggested to us that even key employees might come and go. Instead, each employee invited to participate would be granted units from a pool depending on years of service. Units could also be re-deposited back into the pool upon departure of a key employee.
This allowed seniority and longevity to become valuable, but the owner could also assign additional units as he saw fit depending on an employee’s individual contribution. The owner was also able to grant some units to his children to ensure their long-term legacy and wealth transfer.
In addition, the funding was augmented by cash value whole life insurance to protect the current owner’s interests and to help fund the transfer of ownership.
Recap of Expanding Ownership Issues
Creating ESOPs, buy-in schemes, Buy-Sell Agreements, and the like, for an S corporation requires a talented business law attorney in concert with business consultants who can draft the corporate governance documents correctly. This stuff is state-specific but also must follow national guidelines within the IRS, ERISA, DOL, etc. Let us know if you need help in selecting a proper attorney, and adding some creativity and protection to your scheme.
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