Limiting owner risk in a Stock Bonus Plan can achieve several objectives that move owners closer to a successful ownership transition.
- Transfer his company to a group of his key employees, and
- Make this transfer over the next five to seven years.
The first hurdle was the employees’ hesitancy to pay taxes on the value of the stock bonus. Let’s talk about the second obstacle in limiting owner risk: keeping employees from pocketing the bonused cash and leaving. We can help to limit owner risk from this scenario using well-designed forfeiture provisions and a Section 83(b) election.
Our fictional owner Earl did not like the exposure he felt awarding a bonus with no conditions. So we recommended that his employee’s stock bonus be subject to a substantial risk of forfeiture. With forfeiture, employees will normally forfeit 100% of the bonus if they leave before the forfeiture time period (sometimes called a vesting period) lapses. The forfeiture time period is typically designed with the owner’s exit date in mind.
For example, forfeiture provisions can be designed to lapse incrementally beginning on the date the bonus is awarded, or when the owner exits, and ending several years after the owner’s exit date. Think of the lapse in forfeiture as the converse of vesting: a 20% lapse of forfeiture is equivalent to becoming 20% vested in a non-qualified plan. Matching forfeiture to your anticipated exit date encourages key employees to remain with a business after you leave. This is a crucial in maintaining transferable value.
We recommended that he consider a forfeiture schedule providing for 100% forfeiture for the first two years after the stock bonus award and then a lapsing of forfeiture over time so that the key employee would receive the entire bonus three years after Earl’s contemplated exit date. This schedule protected Earl from having to pay anything for the stock if his key employee left the company in the first two years. But the company cannot deduct the value of the stock bonus award until or as the forfeiture lapses. Without further planning in the form of a Section 83(b) election the taxation of the stock bonus award is deferred.
The Section 83(b) Election
Earl did not want to give even more to his employees in the form of a gross-up to pay their taxes when the stock vested so we recommended the 83(b) election. Property received for services rendered is taxed as compensation at the Fair Market Value (“FMV”) of that property when it is no longer subject to forfeiture. Section 83(b) states that an employee receiving restricted stock can elect to be taxed for the FMV of the property when it is received, rather than when it is no longer subject forfeiture, so that any further gain is taxed at capital gain rates.
Should an employee leave after the forfeiture on the bonus has lapsed the company typically repurchases, with after-tax dollars, the bonused stock, at its then current value.
Earl decided that the best way to achieve his objectives and motivate, handcuff and reward his key employees was to implement a Stock Bonus Plan with an 83(b) election and cash gross-up.
Earl’s company required the covered employees to sign a Non-Solicitation Agreement and Protection of Proprietary Information Agreement as a condition of receiving the stock bonus. The company also put in place an agreement to buy back the stock should an employee leave the company. These restrictive agreements play a central role in limiting owner risk. To make these agreements more acceptable to employees, we recommend introducing employees to Non-Solicitation Agreements in tandem with incentive plans.
It’s important to work with experienced counsel in designing and drafting stock bonus plans, but regardless of the design, the plan is only worthwhile if it moves you closer to the objectives you set early in the Ownership Transition Planning Process.
As Earl’s case illustrates, a Stock Bonus Plan can achieve several objectives that move owners closer to an ownership transition while limiting owner risk. Earl’s plan:
- Rewarded key employees for performing at a superior level;
- Motivated employees to increase company value to the level necessary to provide Earl with financial security;
- Retained key employees for years after his departure date;
- Facilitated the transfer of ownership to Earl’s chosen successors.