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Restrictions when stock is transferred to an employee

October 31, 2017

On occasion a primary owner might want transfer some ownership or stock to an employee. Regardless of the value and how it is treated for tax purposes, and whether it will be reported properly [it should], there must be restrictions placed on the employee from transferring those shares. Not having restrictions has the potential to cause serious damage to the company.

Improper tax recording or a failure to document the valuation can result in some tax or financial penalties and if the transaction is de minimis in size, the cost won’t really be significant. However, without restrictions on a later transfer the company could end up with owners it would not want. My suggestion is to do everything right, but in that absence then at least impose restrictions on a further transfer of that ownership.

Without restrictions the ownership could be transferred to a spouse, children, siblings, an elderly parent or other heirs or even to an in-law or soon to be former spouse. It could also be transferred to a creditor, competitor, major customer, another employee or a bankruptcy trustee. If not all, then most of these would not be wanted as co-owners.

The restrictions should be in the form of an owners’ agreement, i.e. a buy-sell agreement. A buy-sell agreement signed by all owners would be the best way to restrict the transfer. An alternative would be to have the shares placed in a trust for family members which would also be part of an asset protection and wealth transfer plan. And another alternative, which should also be used in conjunction with the buy-sell, but can be used without it, would be to place an iron tight clause with restrictions on transfers prominently on the document evidencing the ownership, e.g. stock certificate or partnership or members’ agreement.

The reason the buy sell agreement is best is because it would spell out every situation where a transfer could occur and would cover why transfers cannot otherwise be done. The agreement would contain restrictions on transfers because of death, disability, personal bankruptcy, execution of a judgment or tax lien, retirement, no longer being employed by the company and myriad other circumstances. It would also work out the valuation amount and the method and terms of payment.

Once shares are issued without the buy-sell or restriction clauses it is very difficult, at best, to have the owners agree to restrictions. The only lever is when additional shares are to be issued and that is made contingent on permitting the restrictions on the previously issued shares.

This is a serious matter and needs special attention beforehand to make sure that very grave, burdensome and costly future problems are avoided.

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