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Key Employee Retention Plans for Closely Held Businesses

March 23, 2022

In rewarding key employees of a closely held or family-owned business, it is important to develop a key employee retention plan and to develop such a plan in the context of developing an owner/manager exit strategy so the two plans complement one another rather than conflict with one another.

In developing the two plans, it is important to

  1. Begin the planning early

  2. Consider many alternatives

  3. Remain flexible

  4. Communicate openly and listen to key employee suggestions

  5. Above all else, determine what is best for the viability, prosperity, and growth of the business.

If the owner intends to sell the business one day to outside third parties, he should consider providing job security to his key employees, for example, by offering them employment agreements. Whether or not the owner plans to sell the business to outside third parties, he should consider providing both monetary and non-monetary incentives to remain with the business for the long term.

The owner has to decide whether he is willing to make his key employees co-owners. If he is, there are numerous equity based plans that can be adopted which phase in such ownership to provide the maximum incentive to remain with the company. Co-ownership can also be accompanied by a stockholders agreement which protects the company from early voluntary termination.

If the owner is not willing to make his key employees co-owners, he can nonetheless provide them with a cash or deferred cash compensation plan which is equivalent to co-ownership in many respects. If the owner is not willing, to reward the key employees based on the net income of the whole company, he can nonetheless develop bonus or deferred compensation plans which are formula based, tax deferred compensation programs that have vesting requirements which require the key employees to remain with the company to earn all the offered benefits.

The success of many family owned or closely held businesses is due largely to the efforts of the founder/owner/manager. But unless such businesses have capable successors and key employees, many of such businesses cannot survive the departure of the founder/owner/manager. If the owner/manager departs and these key employees leave instead of adapting to new owner/managers, the business may suffer irreparable harm. Therefore, a business succession plan should be developed to identify and retain key employees.

It is extremely useful for the owner/manager to know the demonstrated needs of his key employees. For example, some key employees may desire an equity stake in the company. Others may be more motivated by more current income or more income upon retirement. Some may be motivated by being granted more responsibility. Others may seek job security.

Although the owner/manager may not be willing to provide everything employees want, before embarking on a strategy, the owner/manager should at least know what is desired and have a strategy for dealing with those desires and providing alternatives if those desires cannot be met. Ultimately, the appropriate retention strategy usually contains a combination of monetary and non-monetary components.

If the owner/manager is considering selling the business to his key employees or all his employees as one alternative for his exit strategy, there are several alternative structures for such a transaction. The owner must consider the company’s ability to finance the purchase out of its cash flow while financing working capital needs and growth plans.

Delegating responsibility for some decisions which allow key employees to contribute to the success of the business and enhances their perception of their value to the business can be just as important as properly rewarding key employees with appropriate compensation. Employees are more likely to stay with a company that involves them in the planning process and convinces them the owner’s vision for the future can become a reality and involves them.

Although it is not the only motivating factor for most employees, monetary incentives used effectively are a key factor in retaining valuable employees. It is important that the owner/manager knows at all times what the prevailing wage/compensation rate is in his industry for the positions which constitute his key employees. In addition to providing competitive based compensation, there are other monetary incentives that can be offered as part of a total compensation package. For example, bonuses for meeting performance based goals, stock options, deferred compensation and providing for an employee’s retirement.

In addition to providing key employees with the necessary monetary incentive, companies may be able to use taxable as well as non-taxable fringe benefits as additional retention and motivation tools and stock based compensation plans as well in those situations where the owner/manager is prepared to give stock or sell stock to his employees. Many fringe benefit programs are subject to ERISSA requirements.

For this purpose, the most important of such requirements is compliance with the non-discrimination rules. This means that, if implemented, a fringe benefit program must be made available to all employees or all employees at least who have been with the firm for some minimum but uniform period. Many of these broad based fringe benefit programs, such as medical reimbursement plans or group term life insurance policies can be provided tax free to employees.

In the case of group term life insurance there is a ceiling for the benefit to be classified non-taxable. There are some tax-favored fringe benefits that are not subject to the non-discrimination rules. Some of these benefits can be provided to key employees on a tax free basis. For the most part these benefits are small e.g. personal use of a company car, business related educational conferences, moving expenses reimbursement, on premises perks, e.g. athletic facilities etc. There are other fringe benefits that have an income tax component but are not subject to the ERISSA non-discrimination rules, for example, split dollar life insurance.

Although written employment contracts are relatively rare in family-owned or closely held businesses, they can be useful in certain situations to help hire or retain key employees. From an employee’s standpoint, such a contract can provide a measure of security as well as spelling out the rewards that can be expected if defined levels of performance are achieved.

Further, if the owner’s potential exit strategy is to sell the company to third parties, the existence of employment contracts with key employees can provide the necessary measure of security which those employees need in the face of the unknown which always accompanies a sale. In some cases the existence of employment contracts with key employees enhances the value of a business because the purchaser can have some assurance the key employees will remain with the company after the transaction is consummated.

In other cases the existence of employee contracts can be problematic for the potential purchaser and, as a result, the value of the business may suffer. It is important for the owner to objectively evaluate his business and the contributions made to the business by key employees in determining whether the existence of employment contracts is a benefit or not to the potential purchaser. From the employer’s standpoint, besides being a means to document the employees compensation arrangement, the benefits of an employment contract include the ability to provide for such provisions as a non-compete clause, a non-disclosure and/or trade secrets clause and an assignment of invention clause.

Providing key employees with an interest in the business through the sale of equity or the development of an equity based compensation plan can be an extremely effective way to retain the services of key employees. Many closely held businesses do not want to involve employees in the decision making process which owners may be required to participate in, for example, in the event of a sale of the business. However it is important that owner/managers realize that equity based compensations plans may still be used in creative ways without giving up absolute control.

For example, with the amendments to the Internal Revenue Code regarding Subchapter S corporations, it is now possible to create a class of voting common stock as well as non voting common stock. In addition, under certain circumstances, there can be convertibility features between these two classes. The only remaining requirement for a Subchapter S corporation regarding the one class of stock rule is that rights in liquidation of the corporation and to all distributions such as dividends must be uniform among all shares of stock.

Furthermore, the sale of stock to key employees can be accompanied by a shareholder agreement pursuant to which the rights of ownership are subject to such agreement. For example, if the employee should desire to leave the company, he can be forced to sell the stock back to the company or to remaining shareholders. In addition to equity based compensation plans, there are also other types of incentive plans that do not involve the transfer of an actual ownership interest but compensate key employees as if they were owners of equity securities.

Rather than selling the shares outright to a key employee, a more common approach would be to create a restricted stock plan in order to transfer stock to an employee subject to certain restrictions spelled out in the plan. Under a restricted stock plan shares are often transferred to an employee at no cost or at a bargain price but are subject to substantial forfeiture provisions if the employee fails to fulfill the terms of the plan.

The arrangement can be structured so that the employee earns ownership of the stock over time yet obtains certain economic benefits, for example the opportunity to participate in the growth and value of the company immediately. From a tax standpoint, the grant of a restricted stock award is not taxable to the employee or deductible by the corporation until the substantial risk of forfeiture associated with the grant of restricted stock lapses.

Incentive stock options or so called “ ISO’s” provide key employees with the opportunity to share in the appreciation of the company’s stock value. Because the employee is not required to commit any capital until the stock has appreciated in value, the grant of an ISO may motivate an employee to take a long range view in their commitment to the company. One benefit of ISO’s as compared with other employee benefit plans is that the qualified ISO plan is not subject to the ERISSA rules regarding non-discrimination.

There are substantial tax benefits associated with an ISO. Neither the grant of an option nor the exercise of the option creates compensation income to the employee, although when the employee exercises the option, presumably he will only do so if the stock has substantially appreciated in value. There is however, an alternate minimum tax adjustment required upon the exercise of an ISO. The employee recognizes taxable income or loss only when the stock acquired through the exercise of the ISO option is disposed of.

In order for the employee to receive favorable capital gains tax treatment upon the sale of the stock received pursuant to the exercise of an ISO option, the employee must hold the stock for a period equal to the greater of two years after the grant of the option or one year after exercise of the option.

A nonqualified stock option is any option that does not meet the requirements of an incentive stock option. Nonqualified stock options do not have the same tax benefits for the employee as ISO’s but are more flexible. Like an ISO employers can use nonqualified options to provide key employees additional compensation through the opportunity to share in the appreciation of the company’s stock value over time. The principal benefit attributable to a nonqualified stock option as compared to an ISO is that it may be granted at below fair market value on the date of grant and thus provide the employee with an instantaneous receipt of value and presumably providing additional incentive to remain in the employ of the company.

If a nonqualified option has a readily ascertainable fair market value on the date of grant, the value of the option must be included in the employee’s income at such time, unless the option is subject to a substantial risk of forfeiture or is not transferable. The fair market value of a nonqualified option is not readily ascertainable unless the securities are actively traded on an established securities market or it meets certain conditions which would not be the case in a closely held corporation.

Accordingly, in almost all cases the employee does not receive taxable income until he actually exercises the option and acquires the underlying stock and the company does not have a corresponding deduction until such date. Once the employee exercises a nonqualified stock option, there is no minimum holding period. However, if the employee holds the underlying common stock for less than one year, the tax on any gain above the exercise price will be short term capital gain. If the employee holds the common stock for more than one year from the date of exercise, the employee will be entitled to long term capital gain treatment.

Frequently business owners do not want to dilute their ownership by giving shares or the right to buy shares of the company’s stock to key employees. There are, however, equity oriented compensation programs that do not result in actual transfer of stock. These programs provide for cash compensation determined by reference to the company’s stock value. Although actual shares of stock are not transferred, the employee is compensated if the stock’s value increases. Either book value or a formula price based on earnings and cash flow is often the measure utilized. Two common equity-oriented plans are known as Stock Appreciation Rights and Phantom Stock Plans.

A stock appreciation right (SAR) is the right to receive cash compensation based upon the increase in the value of a specified number of shares of stock during the measurement period which is the spread in value of the shares between the date of grant and the date the SAR is exercised.

In a typical SAR arrangement, the key employee will be given an assumed base investment equal to a certain amount of the company’s shares as of a certain date. The assumed investment or shares is valued at a specified price, for example, for a closely held corporation, the current book value of the shares might be utilized. Upon the exercise of the SAR or the sale of the company, the key employee receives compensation equal to the appreciation in the specified amount of the shares in accordance with the valuation method utilized.

The appreciation is measured by the difference in the specified value of the stock on the agreement’s expiration date or company sale date and the specified price on the date the agreement was entered into. The agreement’s termination can be tied to specific events, such as the employee’s retirement, death, termination from the company or merely a specified period of time. The compensation can be paid in a lump sum, installments, or a combination thereof.

The net value of the SAR is taxed to the employee as compensation income when the cash is received, unless the employee is in constructive receipt or realizes an economic benefit at an earlier date. The compensation income is subject to regular federal income tax withholding and employment taxes. The corporation has a corresponding deduction when the employee recognizes the income.

A Phantom Stock Plan is used to duplicate the benefits of a restricted stock grant without actually transferring the shares. Under a typical Phantom Stock Plan, a participant’s account is credited with a stated number of units equal to a certain number of shares as of certain date. Each unit is equal in value to a share of the employer’s stock. Most closely held businesses use current book value to measure stock value.

However, another formula may be chosen. A Phantom Stock award is outstanding for a period specified in the plan, for example, five years. At the end of the measurement period the key employee receives compensation equal to the units’ appreciation measured by the difference in the value of the units at the end of the period and their value on the date of the agreement. It is possible, but not necessary, to credit the employee with any dividends or similar distributions on the equivalent number of shares during the period that the units are held in the plan.

As with SAR’s, the cash amount due at the end of the period may be paid in a lump sum, installments or combination. Phantom Stock Plans and Stock Appreciation Rights Plans are very similar and controlled by the terms of the agreement which created the plan. However, Phantom Stock Plans are usually established for a fixed amount of time whereas a SAR’s termination date is normally tied to specific events or the exercise of the SAR by the employee. A Phantom Stock Plan does not usually allow the employee to exercise his rights under the agreement before the end of the specified award period.

An alternative to stock based plans is a deferred compensation plan which is classified for federal income tax purposes as either a qualified or non-qualified plan. Qualified plans defer compensation until retirement for a broad range of employees. The most common types of qualified deferred compensation plans are profit, stock bonus, 401(K), defined benefit pension, money purchase pension and employer-sponsored IRA’s. However, since these plans must be offered to a broad range of employees because of ERISSA requirements, they are not usually considered a viable option as incentives developed especially for key employees of close corporations.

Non-qualified plans typically defer compensation only for key executives and management personnel. In a non-qualified deferred compensation plan, the employee’s receipt of a portion of his compensation is deferred to a future year. The amount deferred can be a specified amount or a formula amount such as a percentage of the employee’s compensation or a percentage of corporate profits.

A deferred compensation plan can be looked upon as a bonus arrangement which is not paid at the time of determination but rather is deposited in a deferral account in the key employee’s name. The employee is entitled to receive the balance in the account upon the occurrence of a specified event such as retirement, death or after a specified number of years.

In addition, the Company can impose vesting requirements, for example, all or a portion of the deferred benefits are forfeited if the employee voluntarily terminates his employment within five years of the creation of the account. These requirements can be used to entice an employee to stay with the company. The income tax treatment of the compensation will also be deferred if there is a substantial risk of forfeiture.

The options available to the closely held or family owned business to incentivize key employees are numerous, but care needs to be taken in adopting any one approach.

The above is intended to provide general information not specific legal advice or a recommendation. Legal advice can only be rendered to clients who have a retainer relationship with the law firm. To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.