WIPP's myContracting Magazine January 2015 - Page 13

The company has significant value today. The company would therefore be delivering to the key employees a valuable asset (restricted stock) which is likely to appreciate significantly over time.

For certain tax efficiency reasons (which go beyond the scope of this blog post), the company presumably want to allow the key employees to accelerate and minimize the amount of ordinary income tax on the receipt of the restricted stock (by making and filing an 83(b) election) and to lock in all future income recognition (provided certain requirements are met) at capital gains rates. (Note: Not allowing the Section 83(b) election could lead to even more challenging (tax) scenarios to the key employees going forward).

But, this would lead to some other potentially thorny and unintended consequences for the Company (and Owners). First, if awarded restricted stock, the key employees would, at the time of a sale of the company event, share in the full value of the company (and not just the part tied to their efforts to take the company form level x to level y). Second, the above-referenced Section 83(b) filing and payment of taxes would, for tax purposes, make the key employees full shareholders in the company right away; regardless, of the fact that they would not yet have vested to and therefore would not truly own any of the restricted stock. Remember, the company is an S corporation and can only have one class of stock. This means that all stockholders must be treated them same and have the same financial/economic rights. The company therefore would not be able to treat the key employees any differently than the Owners. Any time the company would make pro rata tax or other distributions to the Owners, the company would have to make matching pro rata distributions to the key employees. Moreover, any company efforts to condition the key employees’ receipt of discretionary distributions until having vested to the stock (for example, by way of depositing them into an escrow account and releasing upon vesting), could be viewed as the company having created a second class of stock, which could well jeopardize the company’s S corporation tax status. It is likely that some form of equity-linked plan (such as a SARs plan), as opposed to an equity plan, would better match to and achieve the company’s goals and objectives.

As you can see, choosing the wrong employee incentive plan could undermine a company’s goals and objectives and lead to other unfavorable consequences. So, choose wisely.

Dean Nordlinger is a partner with PilieroMazza and heads the Business and Corporate Law Group. He may be reached at dnordlinger@pilieromazza.com

"... a company’s owners’ challenge is to strike the right balance between allowing key employees’ to share in the company’s upside success, while protecting the company’s downside risk."