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Employee Compensation

Normalizing Adjustments and Valuations

Normalizing Adjustments and Valuations

by | Jun 27, 2016 | All Blog Entries, Corporate, Employee Compensation, ESOP, Succession Planning

Valuations frequently assume a third party will purchase a business and primarily run it unchanged.  This does not mean a buyer will continue to pay expenses or a level of expense not considered typical.  Non-operating assets are typically excluded from a valuation, too.  Normalizing adjustments take the atypical expenses or portion of expense (or income) out of the mix.

Non-operating and one-time items include but are not limited to gains and losses from the sale of assets, income and expenses related to investments and legal settlements.  Expenses related to layoffs are an example of operating but non-recurring expenses generally removed.  If an income source or expense is not related to ongoing operations, it is subject to adjustment.

Discretionary adjustments look to income sources or expenses over which an owner has a choice.  Compensation paid to owners and officers as well as rent paid to related parties are frequent candidates for a discretionary adjustment.  Rent paid to a related party is often based on the cash flow requirements of that related party.  For a property with no mortgage, for instance, below market rent may be paid.  This is an example of how adjustments can work as a reduction of expense or an addition to expense.

Various authoritative sources report officer/owner compensation based on industry type, size and location.  These sources can form the basis for this adjustment.  Real estate appraisals are frequently used as the source for an adjustment to market rent.

Controversy exists over whether to include “discretionary” adjustments when valuing a minority interest.  Opponents say no, correctly stating a minority owner has no control over these discretionary expenses.  Proponents argue these adjustments should always be considered.  Shareholders of publicly-traded companies will invest elsewhere if they deem company management is overpaying executives, for example, resulting in a lower return on their investment.  A growing lack of investor interest leads to a decline in share price.

Proponents point to the derivation of yields used when calculating value based on cash flow.  These yields are often based on data from public equity markets.  As investors price shares and the related returns based on how well management is running the company, a perceived overpaying of expenses will lead to lower share prices and returns.

83(b) Elections and the Smaller Business

by | Apr 27, 2016 | All Blog Entries, Corporate, Employee Compensation

We continue our series of articles on compensation with this blog on IRS Section 83(b) elections.

A section 83(b) election allows an employee or contractor to include in taxable income the fair market value of property they received for the performance of services before they are truly entitled to that property.  With small businesses, this often occurs with restricted shares granted to employees or contractors that vest over time.  The election does not apply to stock options.

Without the election, with shares that have yet to vest and which the recipient can’t transfer, the fair market value of those shares is included in income when either the shares are theirs or the shares become transferable.  Generally, that means as the shares vest.

The 89(b) election allows the recipient to recognize all the income associated with all the shares at the date of grant, presumably at a lower value.  For tax purposes, all shares are treated as if they are fully vested.

If share value is expected to rise over the vesting period, electing 83(b) is a smart choice.  The election starts the clock for capital gain recognition should the shares be sold or transferred in the future.  It also determines that taxable basis for these shares when later sold or transferred.

Electing 83(b) should not be considered a slam-dunk.   Even with a start-up, shares have value.  This may be influenced by venture capital investments or other equity funding occurring at the same time as the restricted shares grant.  And it is quite possible that when the shares do vest, their value may be lower than at the time of grant.  Lastly, an employee who leaves prior to the completion of the vesting period will have paid taxes on compensation never fully received.

An 83(b) election is smart if the amount of income reported at grant is small, the share value’s growth prospects are moderate to high and the risk of share forfeiture through employee termination is very low.

An 83(b) election must be supported by a valuation of the shares in question.  JBV has significant experience and expertise in that area.

A tax specialist should assist with the election to avoid any tax consequences.

At JBV, we are here to assist you.

Stock Options and the Smaller Business

by | Mar 7, 2016 | All Blog Entries, Employee Compensation, ESOP

Stock options and stock ownership plans are a popular and effective method of incentivizing employees, often at a low cost to both the employer and the employee. Several types exist, including non-qualified stock options, incentive stock options, employee stock ownership plans, phantom stock, stock appreciation rights and more. In this second of a series of articles, we will look at Phantom Stock Options and Stock Appreciation Rights.

Phantom Stock Options and Stock Appreciation Rights

Under traditional stock option plans, an employee can become an owner of the company. Often, a business owner does not wish to pass along ownership. But s/he does want to incentivize key employees. Phantom stock options (“mirror stock” or “shadow stock”) and stock appreciation rights (SARs) both provide these features.

As with other stock plans, a set of milestones can be established. The “shares” are “issued” when the milestone is reached.

Phantom stock plans are tied to long-term company performance. There are advantages to both the employer and employee traditional stock plans don’t offer. Employees do not need to invest any money. Nor are they subject to corporate governance issues that may arise. They cannot be asked to personally guarantee company obligations. Most importantly, if they wish to sell shares under a traditional plan, their options may be limited. Typical smaller businesses are not traded and often do not hold any defined means for redeeming shares. This issue is not relevant for a phantom plan.

For an employer, the shares are “phantom”, the employee is NOT an owner. These employees hold no authoritative input in the management of the business. Yet, the employee can be incentivized through additional value added to the business, much like an owner. Administratively, these plans are much less complex than traditional stock option plans.

For the employer and the employee, the exercise of the option becomes an immediate taxable event. The employee reports it as ordinary income; the employer as a deduction.

With a SAR, many of the same advantages exist as with phantom stock. The key differences are in the exercise of the option and the amount of the award. A SAR can be exercised at the employee’s discretion once the vesting schedule is met. A phantom plan calls for exercise at the time the vesting schedule is met. A SAR awards the employee the amount equal to the difference between the FMV of the underlying stock at the exercise date and the grant date. The recipient of phantom options receives the full value of the share.

An attorney and a tax advisor should design the plan with your guidance to avoid any legal or tax consequences.

At JBV, we have valued many stock option plans, from ESOPs to phantom stock and SAR plans to ISOs and more. We are here to assist you.

Stock Options – Non-Qualified Stock Options and Incentive Stock Options

by | Feb 19, 2016 | All Blog Entries, Corporate, Employee Compensation

Stock options and stock ownership plans are a popular and effective method of incentivizing employees, often at a low cost to both the employer and the employee.  Several types exist, including non-qualified stock options, incentive stock options, employee stock ownership plans, phantom stock, stock appreciation rights and more.  In this first of a series of blog posts, we will look at non-qualified stock options and incentive stock options.

An employee stock option is a contract issued by an employer to an employee to purchase a set amount of shares of company stock at a fixed price for a limited period of time. There are two broad classifications of stock options issued: non-qualified stock options (NSO) and incentive stock options (ISO).  NSOs are typically offered to non-executive employees and outside directors or consultants.  ISOs are reserved for employees, generally executives.  Tax treatment of the two differs as well.

Both plans operate under a vesting schedule.  The employer grants the shares on Day 1 Year 1 but may set a vesting schedule.  Many schedules are based on time: 20% vest at the end of Year 1, an additional 20% at the end of Year 2, etc.  Other vesting schedules are tied to milestones: 20% when sales have reach $15 million, or 20% when productivity reaches 75%.  Both types of vesting schedules need to be clearly documented and agreed to.

Under both plans, no taxes are due at the time of grant.  NSOs are taxed at the date of exercise.  The difference between the Fair Market Value (“FMV”) on the grant date and the FMV on the exercise date is taxed as ordinary income to the recipient and as expense to the company.

ISOs are not taxed when the options are exercised. When the securities are sold, they are taxed under capital gains rules.  If the securities are held for one year after the option exercise and two years after the date of grant, they qualify for long-term capital gain treatment.  If these two qualifications are not met, they are treated as non-qualified stock options and are taxed using ordinary income rates.

An attorney and a tax advisor should design the plan with your guidance to avoid any legal or tax consequences.

At JBV, we have valued many stock option plans, from ESOPs to NSOs to ISOs and more.  We are here to assist you with yours.

IRS May Try to Restrict Discounts

by | Jul 27, 2015 | All Blog Entries, Corporate, Employee Compensation, ESOP, Succession Planning

At the American Bar Association (ABA) Section of Taxation meeting on May 8th, 2015, Catherine Hughes, of the Office of Tax Policy in the U.S. Treasury Department, announced that proposed regulations under section 2704(b)(4) could be released before the fall. She indicated that the tax community could look to the Obama Administration’s prior budget proposals on valuation discounts for clues about what the proposed regulations might provide.

Section 2704(b)(4) states:

The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if the such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.

Many believe the IRS does not have the authority to ignore minority and marketability discounts without Congressional action.

The IRS has unsuccessfully tried the Congressional route before.

A proposal was included in President Obama’s budget proposals in each of fiscal years 2010 to 2013. These proposals called for the elimination of discounts in family-controlled entities. None made it to the final approved budget.

Within the last ten years, the Certain Estate Tax Relief Act of 2009 appears to be the sole introduced bill on the topic. (Note my search was unscientific and may exclude other recent actions.)

HR 436: “Certain Estate Tax Relief Act of 2009”

This bill proposed the elimination of the ability to apply discounts for lack of marketability for transfers of “nonbusiness assets” of an entity. “Non-business assets” are those that are “not used in the active conduct of one or more trades or businesses.” For example, the new law would disallow a lack of marketability discount for the transfer of an interest in an entity that relates to the entity’s holdings of marketable securities.

Exceptions would have applied to two particular types of assets. First, an exception would have been made for real property owned by an entity is which the transferor materially participates, which would be measured in a manner similarly to passive activity limitations for income tax purposes. Second, an exception would have existed for “reasonably required” working capital of a trade or business.

Additionally, the Bill disallowed any minority discount for transfers of interests in a family controlled entity. This would have attributed ownership of the transferor to their spouses, parents, children, grandchildren, etc., thus eliminating the minority interest discount.

Status – Died in Congress

Does this mean the current attempt will fail? Who knows! However, panic mode is not called for.

Sales of Privately Held Businesses Are On the Rise December 2014

by | May 3, 2014 | All Blog Entries, Corporate, Employee Compensation, ESOP, Succession Planning

The economic recovery has created a surge in sales of small businesses. The number of deals tracked by online marketplace BizBuySell.com rose more than 40 percent in the third quarter. Behind the trend: Baby boomers want to retire, businesses are healthier after the recession and buyers are finding it is easier to finance deals.

At the low point of the recession – the second quarter of 2009 – BizBuySell logged just 1,040 closings. In the third quarter of this year 1,685 sales closed.

Expect sales to continue at their current hectic pace, says Curtis Kroeker, a general manager at BizBuySell.com.  “Next year could be a year of extreme growth, given the trend we’ve seen this year,” Kroeker says.

Many owners had hoped to get prerecession prices but lowered them after finding few takers. But don’t worry about sellers. They’re still doing fine, Kroeker said. The average selling price for a small business is up 3.4 percent from a year ago, and more people have the financial ability to buy a company since the recession.