Are you considering rewarding a long time loyal employee with a small percentage of ownership interest in your family business?   After all, rewarding your long term employee with ownership interest in your business will insure that he or she will stay around as an employee and give him or her incentive to be invested in the future of company.  Right?

As a controlling owner of a family business, you need to think twice before giving an employee ownership in your business.  There are complex tax issues, as well as business law issues, to consider before deciding whether to transfer equity interest to an employee.

Tax Issues:

Some people believe that a transfer of ownership interest to an employee, whether such transfer is coming directly from the owner or from the company, will not generate any tax consequences to the parties involved and would be treated as a gift. Wrong!  A transfer of an ownership interest in a business entity, whether shares of stock from a corporation or interest (that is a capital interest (as distinguished from a profit interest)) from a limited liability company, will likely generate taxable W-2 compensation to the employee at the time the equity interest becomes vested. The amount included in taxable income of the employee would be based on the fair market value of the equity interest at the time the equity interest becomes vested.  If the ownership interest were issued to the employee by the company, the company will receive a deduction based upon the amount included in the employee’s income.  If an individual shareholder or member were to directly transfer his or her stock or membership interest (that is a capital interest (not solely a profit interest)) to the employee, the IRS will likely recast the transfer of equity interest as a contribution of capital by such individual to the company and immediately thereafter as a transfer by the company to the employee, thus resulting in the employee receiving W-2 compensation based on the value of the equity interest.   It should be noted, however, under current tax law, a transfer to an employee  of a profit interest (without the right to current capital) in an entity that is taxed like a partnership will not subject the employee to taxation; provided, however, there are certain exceptions, i.e. when the entity has a predictable stream of income that can be measured.

Business Issues:

As a controlling business owner with a minority owner, caution should be taken when operating the business.   Care should be used when taking actions on behalf of the company, so that such actions are in the best interest of the company and not solely for the benefit of the controlling owner. Controlling owners have a duty of loyalty to their business, whether a corporation or a limited liability company, and should avoid transactions that involve self-interest when there are minority owners. Self-interest transaction may include paying excess salary and personal expenses of the controlling owner or paying preferred distributions to the controlling owner without paying the minority owner. Additionally, loaning money to and from the respective company, as well as transactions with affiliated companies owned by the controlling owner may cause issues with minority owners, and those minority owners could assert a claim for breach of fiduciary duty or bring a derivative lawsuit.  Transactions should be fair, have a business purpose and should be approved by the disinterested parties, if possible.

It is also recommended that any ongoing relationships with a minority owner should be in writing in the form of a shareholder agreement or operating agreement, as applicable.

To learn more about a transfer of ownership interest in your business, contact Christy Woods at cwoods@gfpac.com or call 239-514-1000.

Please note the above comments are not intended to be all inclusive, and there are various exceptions to the above tax and business rules. Additionally, the above commentary is not intended to give legal business and tax advice.

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Christina Woods has practiced law in Southwest Florida since 2005 and has more than fifteen years of experience representing closely held and family owned businesses. She focuses her practice area on mergers, acquisitions, formation and disposition of business entities. In addition, she addresses matters involving the operations of business entities, entity ownership, entity structure, individual tax planning, and business tax planning.