Whenever you have very important employees in a business, it’s always a good idea to at least make them part owners of the business so that they are motivated to stay on-board, especially during difficult times. The problem you face here however is that by “giving” stock to these important employees, you may be creating a tax headache for them – because the IRS will count this as part of their overall taxable compensation. The IRS sees the value of these stocks being equivalent and the same as if you had given them cash/money of the same value – and so it is taxed accordingly.

This is particularly ‘sticky’ if the company has been in operation for several years and has an actual value. If it were a new company, it would have been okay to “give” stock (called “founders’ shares”) to the people who will help make it a successful business. Because the company has no real value when it is launched, neither does the stock, so there is no “phantom income”. But if your company has been around and has an actual value, giving stock to your very important employees will require them to report this “phantom income” in an amount equal to the value of your company multiplied by the percentage they own.

So what do you do? You can’t really avoid “phantom income” in this situation, but there are ways that you can reduce its impact on the employee:

• Have your company valued by an accountant or business valuation firm;
• Figure out what percentage of the company you want each employee to have;
• Multiply the value of your company by that percentage, and make that the “purchase price” which the employee will pay for his or her stock;
• Have each employee sign a “promissory note” agreeing to pay this purchase price in three or four years, plus interest; and
• Keep the employees’ salary at the same level, but apply a portion each payroll period to pay off his / her “promissory note”.

Because the employee is paying fair value for his / her stock, the “purchase price” would not be seen as “phantom income” to the employee. The payroll deductions reducing the promissory note would be “phantom income” to the employee, but the tax liability would be spread out over three or four years rather than payable all at once. The employee might also be able to deduct the interest portion of each payment on his note, thus reducing the “phantom income” even further (although the interest payments will be “phantom income” to your company).

The numbers and accounting can get a little tricky in a transaction like this, so be sure to use a good accountant or tax lawyer to sort it all out.

Be sure also to look closely at:

• Preparing a “shareholders’ agreement” between you, your company and all of the new employee-shareholders; an agreement that spells out their rights and obligations as shareholders of your company.
• Issue them with “non-voting” shares so that you keep control over your company and how it conducts business.
• Put fail-safe clauses in that address situations where the employee is terminated “for cause” (e.g. he steals money from your company) or if he/she simply quits.

Good luck!