Incentives for Growing Companies No.5: Legal and Tax Aspects of Compensation

Your business is growing, and you need to recruit the right talent and retain employees who will be helping to create future value. How much you need to pay them will be driven by the market and affordability – but the way they are paid can vary enormously, depending on the stage of business growth, your philosophy, and availability of cash. 

All of these things will determine how you deliver compensation – perhaps it’s very simple and it’s all cash – salary and a bonus, or, maybe because of your ownership philosophy (or even simply cashflow constraints) you’re giving (selected) employees the opportunity to own shares in the business as part of their overall package - either now, or in the future if certain goals are achieved.

Cash is relatively simple – it’s usually taxed when it’s received.  However, once equity enters the mix, things start to get a little more complex when it comes to tax and legal aspects, especially if the share plan operates in jurisdictions, or has participants, outside of the UK.

It’s important to plan the legal and tax aspects of your chosen share plans early in the process to avoid any pitfalls later. With any equity plan, determining for example, how joiners and leavers are treated, or what happens if there is a future sale of the business or change of control, should all be addressed up front, and set out clearly in a “Term Sheet”. This can then be taken by your legal advisors and drafted into a set of Plan Rules.  At this point, there will be lots of discussion about the nitty gritty mechanics of how your plan works in practice – the “what happens if?” questions. Sometimes it may mean you have to refine certain design aspects. So, it’s worth spending time at the design stage, to avoid things unravelling later. There are also administrative legal aspects, such as award certificates and grant documentation to prepare, all of which form an integral part of your share plan.

Another important aspect to consider is whether your employees understand how any equity will be taxed – on what will they pay tax on, and when – especially if the plan is not tax-advantaged. Whilst you generally won’t be able to offer financial advice, it is important to ensure that employees who participate in a share plan have a broad overview of the potential tax implications (both income and capital gains tax) and are encouraged to seek their own financial advice where necessary. Nobody wants to get hit with an up-front tax bill especially if future gains don’t materialise. There may be corporation tax relief available too, to an employer, including for any costs associated with setting up an employee share scheme, for example.

The point is – don’t leave the tax and legal aspects to the end, as an “add-on”.  Early consideration will help with transparent and clear communication to employees. It’s always much cleaner to address these issues early on, much better than having to untangle later.