"GIFTING" EQUITY INTERESTS TO EMPLOYEES

by PAUL D. ROSENBERGER - prosenberger@pumilia.com

There are many occasions when a business owner desires to transfer stock or other ownership interests in his or her business to a valued employee or other service provider. Many people intuitively think that such a transfer is gratuitous and, therefore, has no income tax consequences. It is true that for income tax purposes the value of a gift is excluded from the recipient’s taxable income. Intuition aside, the proper inquiry requires a determination of whether the transfer is a gift. In almost all cases, the transfer is not a gift for income tax purposes, but compensation instead. This results in taxable income to the recipient while triggering, in the case of an employee, withholding obligations on the employer.

Let’s look at a basic example: Andy owns a successful distribution business, in part due to the hard work of Barbara in developing and maintaining strong client relationships. Andy wants to reward Barbara and decides to transfer 10% of his stock in the company to Barbara. Is the transfer of stock to Barbara treated as a gift? Almost certainly, no.

General Principles

Whether a transfer is a gift is a factual question. Long ago, the United States Supreme Court developed a standard for analyzing the gratuitous nature of a transfer: that is, gifts are the result of "detached and disinterested generosity." Stated differently, to determine whether a transfer is a gift, one must consider all of the evidence in front of it and determine whether the transferor’s intention was either disinterested or involved. Over the years the IRS has successfully challenged gift characterization in situations that seem to involve gratuitous transfers. For example, payments made to the widow of a deceased employee (without a pre-existing contractual obligation to do so) generally constitute taxable income to the recipient because the payments are made on account of prior service, and are not deemed detached and disinterested. Similarly, tips to a blackjack dealer are also deemed taxable income to the dealer since they are made with the expectation of current or future benefit to the transferor. In sum, virtually any payment or other transfer made in connection with past services or in anticipation of future economic prospects constitutes taxable income to the recipient.

Transfer of Stock

Stock constitutes property and the Internal Revenue Code contains specific provisions addressing transfers of property to employees or service providers. In general, Section 83(a) of the Code provides that, if, in connection with the performance of services, property is transferred to an employee or service provider, the excess of (1) the fair market value of the property over (2) the amount (if any) paid for the property, is included in the gross income of the person who performed the services.

Section 83 explicitly applies to transfers of stock to employees and service providers. Therefore, it is important to understand its application (and the application of the numerous regulations adopted by the Treasury Department to implement it). With careful planning an employer can devise a plan or arrangement to reward employees with equity interests in the business, while avoiding current income tax consequences. Typically, this is done by issuing stock options to employees. The options are usually issued to the employee with the requirement that the employee pay the company the fair market value of the underlying stock (determined when the options are issued) in order to exercise the options. The result is that the employee shares in the future appreciation in the value of the stock.

These transfers can be effectuated in other ways as well. The employer could transfer stock to an employee subject to forfeiture provisions. The employer could also adopt a deferred compensation plan that rewards employees with bonus compensation in an amount equal to the appreciation in the company’s value.

The good news is that employers can use a myriad of methods to reward valuable employees in a tax-efficient manner, but in order to avoid unexpected tax consequences it is important to understand and carefully comply with the rules applicable to transfers of property to employees.