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Sweat equity: how to reward hard work under an employee share scheme

Thinking of giving away equity as part of an Employee Share Scheme? Find out how to do it without putting your business at risk.
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Among startup entrepreneurs, there’s a common misconception that they can simply give equity away to key employees in recognition of all the hard work they’ve contributed to the business over the years. This is seen as their ‘sweat contribution’.

I have no doubt that this transaction has been executed many times over but I’m here to tell you: there are risks associated with just giving it away and most of them are yours, the business owner.

What’s the problem with sweat equity?

By the time most entrepreneurs turn their minds to issuing sweat equity, the business has generally grown in value substantially, hence the desire to reward key employees.

Therein lies the issue. You’re giving away something of value for far less than its market value. The ATO also has a problem with this and will attempt to tax the transaction in one of several ways

1. Value shifting

By issuing more shares in your business for less than what they’re worth, you’re effectively transferring ‘value’ from one shareholder (you) to another (your employee).

Unless you’re doing this with someone ‘at arm’s length’ (eg. an unrelated party), then the ATO could think you’re trying to shift a tax problem from one person to another. As such, they’ll tax you as if you actually did sell the shares for their market value (which they’ll determine!).

2. PAYG Withholding

Let’s say you’ve just issued ‘sweat’ equity to your employee with a market value of $200,000. How did the employee pay for that equity? Well, they didn’t!

The ATO can deem that your business actually paid your employee a bonus payment (which, in effect, it did) and therefore tax them on it as if it was a cash bonus.

As such, your business will need to pay the ATO sufficient PAYG withholding to cover a net bonus payment of $200,000.

3. Fringe Benefits Tax (FBT)  

Perhaps neither of the taxes above are applied.  Instead the ATO could decide that the issue of shares is a non-cash benefit to an employee of your business.

Based on the above numbers, FBT would see your business paying almost another $200,000 to the ATO for the privilege of issuing the shares!

Still interested in issuing sweat equity? An employee share scheme gives you options  

Under the employee share scheme provisions (ESS), the government has provided employers with a number of ways to issue equity to employees at a ‘discount’ price without attracting any of the above taxes.

These include the following:

Taxed upfront scheme – $1,000 discount method

As the name implies, the business can gift up to $1,000 worth of shares without any tax implications for the employee.

Even better, the employer can also receive a tax deduction for the $1,000.

Tax-deferred scheme

This method provides the opportunity to issue more than $1,000 worth of equity but some restrictions and conditions must be put in place to defer the taxing of the discount provided.

These conditions include:

  • $5,000 salary sacrifice – The employee can be issued up to $5,000 worth of shares under a salary sacrifice arrangement.
  • Real risk of forfeiture – Equity can be issued to employees at a discount but there must be a real chance that the employee will lose those shares if certain conditions aren’t met. Once those conditions no longer exist, the employee will be taxed on the discount they received.
  • Vesting periods – Equity can be issued to employees at today’s market value but they don’t receive any beneficial ownership rights to those shares until some point in the future. Once the vesting period is finished, the employee will be taxed on the discount.  

With all of the options above, there are some other conditions that must be followed. One sticking point is that these offers MUST be given to at least 75% of all employees that have been employed for three years or more, which may not be desirable for your business.

However, if you’re a startup business (less than 10 years old) there is another way!

Access sweat equity with concessions for startup businesses  

Employee Share Option Plan (ESOP) legislation was designed precisely to enable business owners to target key employees and issue them equity at a discounted rate, without creating tax issues for both parties. Although there’s no such thing as a free lunch, this is pretty close!.

Essentially, if both the employee and employer are eligible to participate, the employee can be issued options to purchase shares in the business at a future date based on today’s market value. The difference between today’s market value and the future value is the discount being provided.

However, under an ESOP, the employee won’t be taxed on that discount, and the clock for the 12-month holding period for the 50% CGT discount starts ticking upon being issued the options, not exercising them.

The real benefit of the ESOP comes if your business is less than seven years old. If this is the case, market value (the price the employee needs to pay for the sweat equity) is calculated as net tangible assets, eg. it excludes the value of goodwill! This is a huge advantage.  

Next steps: how to issue sweat equity in your business without creating tax issues

With any of the above options, you’re going to need some tax advice to ensure both the employee and employer are eligible to participate and meet the ongoing requirements.

You’ll also need to prepare an Employee Share Scheme deed that encompasses all the rules and requirements of your business’s Employee Share Scheme.

If you’d like to discuss the merits of an Employee Share Scheme program for your business or want to learn more about issuing sweat equity in your business, then give BlueRock’s Accounting Director Paul Evans a call for a no obligation chat and coffee at our very own Dwayne’s Café.

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