How Can I Give Employees Ownership/Equity in My S-Corp?

Hi, welcome to Council Chronicles with CapEx Legal. Today, we're going to talk about delivering employees equity in a company as a form of compensation, specifically in S corporations. First things first, we should talk about what an S corp is. An S corp is a tax classification. It's not a type of entity.

So if someone comes to me and says they have an S corp, I don't know whether they have a legal LLC. or legally whether they're a C corporation trying to obtain beneficial tax status. In the end, however, there are a ton of rules that govern S corporations, and if you do have an S corporation, it's going to make sense to comply with all of the rules.

The reason people elect S corp status is to create efficiencies in tax savings. A traditional C corporation that's been around for hundreds of years has two levels of taxation. The company is treated kind of like its own person, and the shareholders, the owners of that company, are separate people. So when the company makes money, it's taxed on those profits.

And then when those profits are siphoned down to the shareholders, the shareholders as separate individuals are taxed again. Back in the 1940s and 1950s, this didn't seem like a fully efficient way to approach small businesses. So Congress created the S corporation, which stands for small business corporations.

Rather than creating a double taxation, uh, type of entity, it created a pass through tax status for the entity so that all of the profits and losses of the company would be passed down to its individual owners on their tax returns rather than having double taxation. Now this can create a lot of efficiencies for S Corp owners, and all that efficiency centers around and comes from FICA.

Anyone that's received a W 2 before has seen FICA on their paycheck, and FICA is a 7.65% tax. It funds Social Security, Medicare, Medicaid, and things like that, and what a lot of employees don't realize is that it's actually a two sided tax. 50 percent is paid for by the employee, and the other 50% is paid for by the employer.

Now, when you are the owner of an S Corporation, technically, you're paying both sides of that tax. And so, S Corporations, as pass throughs were created, they create an efficiency there. And so, you're gonna pay both sides of the tax on your salary. But you're only going to pay one side of the tax on your distributions.

So, a classic case for this is a doctor. A doctor might have a million dollars of profits coming in and maybe a market rate for a doctor's salary is $200,000. And so they pay the higher tax rate on the $200,000 salary, but they'll pay the lower tax rate, the more traditional non dual sided 7.65% tax on the $800,000 in distributions they take, which could save them around $50,000 a year in taxes, which is meaningful for small business owners.

Now S corporations can be great and they're great for a lot of companies. They're not great for everyone because there are certain parameters around them. One is that they're limited to a hundred shareholders. Second is that there can only be one class of shares. In a traditional C corporation, what we can do is we create multiple classes of shares to get around various concepts including voting rights and, and company valuations and things like that.

But that's not available in S corporations. We have only one class of shares. And the reason this is really important is that all companies have value as far as the IRS is concerned. If you're a startup, opened 15 minutes ago, you might have a fraction of a cent of value. But if you're an established company, enough to have actual salaries for the owners, then your company has some kind of meaningful value.

And the IRS says you cannot simply give part of a company away. It either has to be purchased at fair market value or whatever company value is given is taxable as bonus compensation. So in a real world example, let's say we're back with the company that has a million dollar value. In that case, the employee, let's say you want to give them 10%, the employee would have to buy that 10% at $100,000.

Or, alternatively, if you want to give that employee 10% of that million dollar company, the IRS will say you're giving them $100,000 in bonus compensation. And that employee will have immediate tax liability as of the date of the grant on that $100,000 as though it was cash. This means the employee is going to have to come up with $30,000 to $35,000 in cash the day they get that equity.

And in a lot of cases, that's not actually going to be a great benefit for employees. It's not a great incentive. They might not have $35,000 to pay in taxes, let alone $100,000 to purchase the company outright. And so in other forms of companies, in C corporations for example, we can create a separate class with a new par value.

Or in LLCs what we can do is create a profits interest, which again is creating a new class of membership interest that has negligible value. We can't do that with S corporations because there's only one class. And we can separate voting and non voting rights in that class, but there can only be one class in the end.

And so we can have various mechanisms that traditional corporations use. We can have stock options, we can have stock warrants if it fits, we can have stock appreciation rights. But in the end, for smaller businesses, true small business corporations, all of these systems might be too comprehensive to really make sense.

The spend that you're going to have creating the structure to give one or two employees equity might not make sense. The system I use in most cases. is a effective buy in. What we'll do is we'll say, okay, employee, you are getting 10% of the company and the fair market value of that 10% is $100,000.

What we're going to do is we as company are going to loan you employee $100,000 on paper, and then you're immediately going to deliver us back that $100,000 to buy your 10% equity. And in this way, there is no real tax issue. And what we do is we structure the note as a securitized note so that when distributions go out from the company, they go to pay off that note.

So let's say again, you've got a company, million dollars value. Let's say it's got, you know, $500,000 in profits a year, 10% of that $500,000 is $50,000. So $50,000 a year is being allocated in profits to this employee that you want to give equity to. We'll take that $50,000 and we'll put it towards the loan so that the company profits that the employee is supposed to get go towards paying off that loan to the company and they're actually buying back their company value over time.

This gives us a few benefits. One, there's no tax issue where they have immediate tax liability. Two, they don't need to come up with a full purchase price immediately to take care of this. Three, it sidesteps the multiple class issues. And four, is it allows us a mechanism to actually handle things in the case of a separation.

Whenever you have an employee coming to company ownership, there's always a risk of that employee leaving. They may leave voluntarily or involuntarily. You might have to fire them because they were stealing from the company, or you might have to let them go because you're downsizing, or you're shutting down a division, or they might want to leave because they just don't really feel a fit with the company anymore.

And we structure the documents in a way that we can create an automatic buyout right if we want. Because 10 years from now, you might not want this employee to actually have equity in the company. You might not want to be giving them profits. And you certainly may not want them to have any kind of voting rights.

And so in any system like this, we want to be really thoughtful of all the, the means and mechanism and the plans of what happens to this company ownership over time. But in the end, when it comes to S corporations, this buy in system through a promissory note, through a loan, is often going to be the most tax efficient system available.

Now, this isn't legal advice because I'm not your lawyer, but if you do have questions about systems like this, it is really important to consult a lawyer. And if you do need one, feel free to reach out at Capex.Legal. Thanks for joining Council Chronicles.