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How Do You Add an Employee as an Owner of Your Company?

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Adding one or more employees as part-owners to a company can be a very rewarding, or very problematic, experience.

The first question is, do you simply want to add one or a few employees as owners? Or, are you interested in creating a formal employee stock ownership plan (ESOP)? This article addresses the first option. If you’re interested in something more formal, such as an ESOP, this is NOT the article for you. Instead, call us to talk about ESOP’s.

If you want to add one or a few employees as owners to the company, the second question becomes, what type of owner do you wish the employee (or employees) become? Some options are:

  • Founder
  • Permanent, but with less rights than a Founder
  • Permanent, but will vest over time
  • Temporary, as long as the employee is working for the company

The above are general categories, and it’s certainly okay to have something different in mind, but what you have in mind will influence what you need to do. Each of these categories has very real-world consequences. Ask yourself:

  • Do I expect the new employee-owner to have the same rights, duties and powers that I (and the other Founders) have?
  • Do I want more powers for myself (and the other Founders), than the new employee-owner?
  • Do I want to retain the right to fire the employee-owner? And if so, will the employee-owner keep his or her ownership once gone?
  • What do I want to be able to do, if there’s a dispute?
  • Can the employee-owner leave? If so, under what conditions? Do I want the ‘right of first refusal’ to buy ownership back, if the employee-owner wants to sell to someone else, or dies or becomes incapacitated?
  • Will the new employee-owner own all his ownership at once, or do I want to grant a little ownership over some period of time, to make sure he or she sticks around?
  • If I have some right to buy-back (or take) the employee-owner’s ownership, how should that be valued? Do I want the option to pay back the employee-owner (or his or her estate) over some period of time?

Depending on how you answer those questions above, it will influence what documents you need to put in place.

Revise Articles and Formation Documents

In all situations above, you will need to revise your formation documents. For a corporation, you will want to revise the Articles of Incorporation as appropriate, for the new employee-owner’s title, authorized shares (if appropriate) and more. You may need to revise the Bylaws, depending on whether you want different classes of ownership or other powers defined. You will need to issue stock certificates.

For a LLC, you will need to revise the Articles of Organization as appropriate, to change from sole-member to multi-member (if appropriate), as well as job title, if appropriate. You will need an Amended Operating Agreement, at least to account for the new employee-owner, as well as make adjustments related to whatever specifics you need to define with respect to the new relationship. For example, adding a “right of first refusal” clause, if none currently exists.

Purchase Agreement (Optional)

In general, it’s a bad idea to “just give” away ownership in your company. This is because you can create unintended tax consequences to the company as well as the new employee-owner. Imagine if someone just gave you 1,000 shares in Apple Corporation. The IRS would view that as a ordinary income to the tune of $159,000 (at today’s stock price of APPL). The problem with a private company, is the ownership you give to an employee-owner is just a piece of paper, and it could be difficult for the employee-owner to meet his or her tax obligations.

Therefore, it’s best to permit the new employee-owner to “buy in” at the fair-market value of the company at the time of buy-in. You can certainly accept payments over time, and you can certainly do it for a $1 instead of fair-market value — just be aware of the tax consequences. Talk to your CPA and/or business lawyer before finalizing.

The Purchase Agreement takes into account the buy-in price, ownership percentage (for a LLC) or number of shares (for a Corporation), as well as makes certain representations and warranties to protect you and the company.

The Purchase Agreement can also make the buy-in subject to certain constraints, such as the requirement to sell it back to the company upon termination of employment.

Restriction Agreement (Optional)

If you want to “restrict” what the new employee-owner can do with his or her ownership, then you will probably need a Restriction Agreement. Such a document is used to put a vesting schedule into place, if that’s your intent. It also prevents the employee-owner from selling or transferring his or her ownership to a third-party, if that is your concern.

Buy-Sell Agreement (Optional)

Finally, a Buy-Sell Agreement is a common tactic to deal with termination of the relationship. This is a document that “pretends” the parties have decided to end the relationship, and outlines all the terms and conditions of such a termination. This is where the purchase price of the new employee-owner’s ownership is established, and how the employee-owner can leave and be expected to be paid for his or her ownership. This document is then placed on the shelf, and if there is ever a termination, it will govern the termination.

This document is more common for circumstances where you have co-equal partners or owners in a company, such as founders. This is because many of the terms and conditions in this document can be placed in the Purchase Agreement for subsequent owners. Therefore, if you are bringing on an employee-owner at a “founder level” and don’t think you need a Purchase Agreement, then you may want to consider a Buy-Sell Agreement instead, to govern the circumstance where either of you want to leave the company.

Contact us if you have any questions, or to assist you in moving forward.

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2 comments

  • I want to retire, and leave all 100% shares of my company (c type corporation) to my employees. If they want to sell the shares, sell the company, sell all equipment and furnishing, that would be fine. But what are the tax consequences to me as sole owner of the shares and my employees as receiver of those shares? The company has fallen on hard times in the past year, but is quickly gaining back business and profits.
    Any advice is welcome.

    • Hi, Ann —

      Thank you for your question. The tax consequences for your employees in that situation depend on how you leave the company to them in the first place. For example, if you gift your shares of the company to those employees, you could be looking at possible gift tax implications, depending on the fair market value of those shares, that could reduce your lifetime exclusion amount for gift and estate taxes. Meanwhile, the employees would use either (i) your tax basis in your shares at the time of gifting or (ii) the fair market value of the shares at the time of gifting to determine what, if any, taxable gain they may have if they turn around and sell/liquidate the company. Which they use depends on which was higher at the time of gifting and what the sales price ends up being.

      Alternatively, if you sell your shares to your employees in an arm’s-length transaction and those employees, in turn, re-sell those shares, you would have taxable gain if the sales price exceeds your tax basis in your shares, while your employees’ taxable gain would depend on what they pay you (which becomes their tax basis) versus what they resell the shares for.

      There are a number of possible scenarios here, and your best bet would be to consult with a local transactional business attorney to come up with a business succession plan that works for you.

      All the best —

      Ian Alden

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