Using the gross-up strategy, there is usually little or no net out-of-pocket cost to a company to cover required taxes.
In Benefits of a Stock Bonus Plan we met Earl Oriole, the 50-year-old, sole owner of a successful wood grill manufacturing company. He told us that he wanted to:
- Transfer his company to a group of his key employees.
- Make this transfer over the next five to seven years.
After a we confirmed that Earl’s key employee group was willing and able to assume leadership, we suggested a Stock Bonus Plan.
On the surface a stock bonus seems like a risk-free reward to key employees. However, employees may not be excited with the offer once they understand the details. The greater the value of the awarded stock, the more challenging the bonus becomes! How can that be?
While the key employee appreciates receiving ownership without paying for it, that value is taxable income to the employee. Key employees must pay that tax with money they may not have or be willing to pay.
Minimizing taxes to the owner is always a critical, but when using stock bonuses, we also consider the key employee’s taxes.
Earl, like most owners, told us that he had no desire to help employees pay the tax on their bonuses. He changed his opinion, however, after we added the following features to the stock and cash bonus plan:
- The Gross-Up Strategy
- Section 83(b) Election
We’ll discuss the gross-up strategy in this article and forfeiture and the 83(b) election in the next.
The Gross-Up Strategy
The gross-up strategy is best explained using an example:
If the fair market value of a stock bonus is $40,000, Earl’s company receives a $40,000 tax deduction, and the employee has taxable income of $40,000. Assuming a 30% tax rate, the employee owes about $12,000 in taxes. Using the gross-up strategy we simply calculate the additional cash bonus required to pay the taxes on both the stock bonus and the initial cash bonus. In this example, Earl would award a cash bonus of about $20,000 to the employee to pay the taxes on both the $40,000 stock bonus and the $20,000 cash bonus.
Using this strategy, there is usually little or no net out-of-pocket cost to a company. Having bonused the key employee $20,000 in cash and $40,000 in stock, the company takes a tax deduction of $60,000. In the company’s 35% tax bracket, the deduction reduces the company’s taxes by $21,000—essentially a wash in terms of cash flow as the company pays a $20,000 bonus but has a $20,000 tax saving.
Of course, a key employee can quit immediately after receiving the stock and cash bonus, and the company is then forced to purchase the bonused stock for $40,000. This after-tax amount requires about $60,000 of pre-tax cash. If this happens, owners are more than a little upset with the ungrateful former employee. How can you protect yourself?
We recommend Stock and Cash Bonus Plans that incorporate well-designed forfeiture provisions which we’ll discuss next time.