Generous Business Owners Beware When Gifting Ownership Interests to Employees

Several times a year we get a call from a small business owner asking if we can help them “gift” one of their valued employees an ownership interest in their company. For the business owner, this seems like a straightforward request and generous opportunity for the employee. But, as it turns out, the proposed gift is not so straightforward and can actually result in not so generous consequences for both the employee and the business owner if certain considerations are not accounted for.

When asked to help, our first question is always the same. What is the reason for the proposed gift? The responses vary, but generally the business owner wants to show their appreciation for the efforts of the employee or incentivize the employee to stay with the company. Other times, the proposed gift is intended to be an initial step of the business owner’s succession plan. In that case, the business owner usually wants to give the employee an easy way in the door with the expectation that the employee will one day buyout the rest of the business owner’s equity.

Beyond the generosity and opportunity associated with the proposed gift, there are important tax and business considerations that must be addressed before any decision to make the gift occurs.

First, the proposed gift can have serious tax implications for both the employee and the business owner. Under the federal tax law, the gifting of an ownership interest in a company from the business owner to an employee is generally treated as compensation paid to the employee —regardless of the fact it is being gifted. As such, an employee would be required to include the fair market value of the ownership interest received as taxable income. Without an additional source of cash flow, the income tax associated with this additional income tax liability could be more than the employee can afford.

With respect to the business owner, if the gift is treated as compensation, the business owner could face severe fines and penalties related to its failure to withhold and remit the appropriate taxes related to the compensation.

There are also several organizational issues that can result from the proposed gift if the necessary considerations are not accounted for prior to the gift. For starters, if the company is owned by a single owner, there is a good chance the governing documents for the company do not account for multiple owners. Often, these gifts are only intended to provide only a right to share in the financial benefits of the company and not intended to give the employee decision-making authority. The governing documents should be amended in conjunction with the gift to prevent any ambiguities with respect to the rights of the employee.

There are also important buy-sell and transfer restrictions that should be considered in the governing documents that restricts the ability of the employee to transfer the ownership interest to a third party without the consent of the business owner.

None of this is to say the proposed gift cannot or should not occur, but often as we work through the process, we find better and more appropriate means to achieve the business owner’s goals. In any event, before committing to any plan to gift an ownership interest in a business to an employee, a business owner should take the appropriate time to consider the reasons, risks, and other potential implications involved so that they can appropriately plan to ensure both the business and the employee receive the most benefit.

Evan Cochran is an attorney in the business and real estate group at Columbus, Ohio-based Isaac Wiles. He is also a certified public accountant licensed in Ohio.