A businessowner who decided to share ownership with his employees writes: “For the past several years, I have operated a very successful service business. We are a limited liability company and while I am the sole owner, I have several W-2 employees. I am concerned that with the job market improving for people in my field, I may lose one or two of my key employees.
I want to make them part owners of the business so they don’t ‘jump ship’ and go to a competitor, but I also want to retain voting control of the business for as long as possible. I also want to set aside a certain piece of ownership for my employees who are not ‘key’ employees, but who are nevertheless valuable. What’s the best way to do this?”
Like corporations, a limited liability company can divide its ownership into “voting” and “nonvoting” classes. That probably is what’s called for here. Have your lawyer draft an operating agreement (similar to a partnership agreement) for you and your employees to sign. That document will create two classes of L.L.C. ownership — a “voting” class, which will be owned by you and your key employees, and a “nonvoting” class, which will be owned by everyone else.
Many L.L.C.s divide their ownership into “units,” which function pretty much the same as shares of stock in a closely held corporation. So, for example, your operating agreement could authorize you to issue up to 1 million “units” of L.L.C. ownership, half of which carry the right to vote on management decisions. You would then issue “voting” units to yourself and (maybe) your one or two key employees. Everyone else would receive “nonvoting” units, entitling them only to share in the L.L.C.’s profits and losses each year.
If you give “voting” L.L.C. units to your key employees, you will have to involve them at least somewhat in management decisions, as they will have legal rights under your state L.L.C. laws. If you feel that is necessary, most attorneys will recommend that you hold onto at least two-thirds of the “voting” L.L.C. units at all times. Note that some state L.L.C. laws give “minority” owners of an L.L.C. the right to sue you, and sometimes even dissolve the company, if they feel they are being “oppressed” by you or otherwise treated unfairly. Also, watch out for “phantom income” taxes. Your employees will have to pay income tax this year on the value of the units you issue to them (whether voting or nonvoting) and they will not be happy about that because they will have to pay these taxes out of their own pockets. Ask your accountant to put a value on your L.L.C., then put a clause in the operating agreement (called a “gross-up clause”) agreeing to reimburse your employees for these taxes.
Another businessowner writes: “My wife and I run a successful dance studio, which is organized as a subchapter S corporation. Our sole dance instructor is our daughter. Right now, my wife and I own all of the shares in the corporation and we want to keep voting control of the company until we are sure our daughter is ready to assume those responsibilities. What is the best way to start giving our daughter shares in the corporation so she will own the whole business eventually?”
You will have many of the same tax issues as the previous reader, but with an additional wrinkle. Technically, subchapter S corporations cannot have two “classes” of stock (such as preferred stock and common stock), but the law does allow a subchapter S corporation to have one class of stock containing both “voting” and “nonvoting” shares, as long as that is the only difference between them. Your certificate of incorporation states that the corporation is “authorized” to issue up to X number of shares total. You will have to amend your certificate of incorporation to divide those authorized shares into “voting” and “nonvoting” shares. Make sure your attorney does this for you, as the actual language can get a bit tricky depending on your state laws.
Once you have divided your shares into “voting” and “nonvoting,” you will need to exchange your existing (voting) shares for a combination of voting and nonvoting shares. You and your wife would then transfer some of your nonvoting shares to your daughter each year, keeping the voting shares for yourselves. Be careful: If you transfer more than $13,000 worth of stock to your daughter each year, you may be liable for federal and state “gift” taxes on the excess amount.