No. 21: Grants and Gifts of Equity
Let’s get straight to the point. My advice to every founding owner that I’ve consulted with over the past 30 years has been simple and consistent on this issue. Stock, or any form of equity, in a valuable Professional Services business should never be treated like a birthday present. As applies to most small business owners, equity should not be given away for any reason.
This is not meant to dash the hopes and dreams of the next generation key employees out there who feel habitually underpaid and entitled to some Equity as a result. The truth is that privately held, restricted and regulated stock has as many continuing obligations as it does opportunities. And owners of equity in the context of a Succession Plan will be actively involved in the long-term success and growth of the business; this requires an investment mindset on the part of G2 (generation two) and G3.
Before deciding if these are issues that you want to fight over, it helps you to know how the mechanics of these processes work. For starters, the terms Granting and Gifting as applied to equity are very different things. A grant of stock is synonymous with the granting of a cash bonus at year end for a job well done. A cash bonus, which most key employees are familiar with, takes the form of a check or ACH payroll transfer and, of course, comes from the company’s checking account. As the money leaves the company’s checking account, it is deducted as an ordinary business expense. As it arrives in the hands of the recipient, it is usually on a W2 basis and taxed accordingly.
A grant of stock, or a stock bonus as it is sometimes called, works the same way except that it has many additional qualifications and complications built in. The stock comes from “treasury” so to speak, or authorized but unissued shares. A stock grant is not an individual to individual transaction. The result is that current owners are diluted.
Many professional service owners I talk to raise the issue of “sweat equity” as to somehow justify a grant of equity because, in fact, it has already been earned. The commonly expressed thought of a founding or senior owner is that “I’m giving this to them because they’ve earned it.” Unfortunately, sweat equity is another term for compensation, something that has indeed been earned (if equity is granted), and that is exactly how the IRS and every state tax it to the recipient.
The final value of the grant and its taxation depend on the issues of vesting, valuation, discounting, tax deferral, tax acceleration, the terms of the Buy-Sell Agreement (i.e., can the recipient cash in the Grant a month later?), voting rights, continuing employment, and governance, and that is the short list. Working with closely held, restricted stock means all the details have to be considered and memorialized and that involves a CPA and an attorney, and probably an appraiser. Stock can certainly be granted, but it has to be done properly and with professional guidance and there is always a tax consequence.
Gifting is quite different. Under the Internal Revenue Code (IRC), a gift is defined as the “proceeds from ‘detached and disinterested generosity,’ …made ‘out of affection, respect, admiration, charity or like impulses.” Established law is clear that this test or threshold cannot be met when an employer gifts stock to an employee. An actual gift that meets the IRC criteria, is not taxable to the recipient. Equity gifted by a business to an employee, or a son or daughter who is an employee of the business, is a taxable event, effectively a grant with all the attendant rules and qualifications.
Estate plans that involve family members in business together are yet a different situation and go well beyond the focus of my books. Gifting in the context of a family estate plan is possible with the help and guidance of professionals, but having participated in a handful of transactions, I can tell you that it is not easy or inexpensive. If interested, start by talking to your estate planning legal counsel and your tax counsel. You’ll also need a formal appraisal to establish the value of the stock as of the date of the gift, for starters. Whenever gift taxes are owed, which is rarely, they’re paid by the giver. Gifts in excess of the annual exclusion also reduce the amount you can pass free of estate taxes after your own death. If you’re a multimillionaire and likely to face these taxes, please consult an estate tax attorney. It might make sense given your circumstances, but it is always on a case-by-case basis.
I’ll conclude by telling you that grants and gifts typically are not necessary to complete a Succession Plan, but that’s not really fair to the handful of successful, more valuable businesses, family or otherwise, in which it might be helpful and financially advantageous. Small business owners with experienced counsel can almost always find a way to achieve one’s goals!
For additional information as applies to next generation key employees and ownership prospects, my new book (Acquiring Your Future Through a Succession Plan) for G2’s and G3’s will be available on March 1st! You will find an interesting strategy for dealing with some of these issues.
Thanks for reading,
David Sr.