One of the key issues facing Australian businesses is attracting and retaining talented staff. While some businesses offer generous additional superannuation, health insurance, and life insurance benefits, it is becoming increasingly popular to offer key employees equity to motivate them to drive growth and remain with the company long-term to maximise the value of the equity they receive.
Two common models for employee equity participation are:
- Offering employee shares as part of their remuneration if they hit performance targets; or
- Allowing employees to purchase equity in the business with their own funds/financing or vendor financed by the business
While both approaches can enhance employee engagement and loyalty, they differ in structure, tax treatment and the associated risks for employees and employers. Understanding these distinctions is essential for businesses considering either option in Australia.
Employee share schemes: Offering equity as part of compensation
Definition and structure
Offering employee shares involves providing employees with shares in the company as part of their remuneration or incentives package. These shares may be given outright or offered under certain conditions, such as vesting schedules or performance targets. The aim is to motivate employees by giving them a stake in the company's success, potentially encouraging a stronger sense of ownership and long-term commitment.
Key features
- In many cases, employees do not need to invest their own money upfront to receive shares. Instead, shares are granted as part of the overall compensation package or as a reward for meeting targets.
- Shares may be subject to vesting periods, meaning the employee must remain with the company for a set period before they fully own the shares.
- Employee Share Schemes (ESS): These are regulated under Australian law, with specific tax treatments depending on the structure. ESS plans can offer tax deferral options to employees, where tax liabilities arise only when the shares vest or are sold.
Advantages for employees and employers
- Lower financial risk for employees: Since employees receive shares without needing to purchase them, they face lower financial risk.
- Increased retention: Vesting periods and performance conditions can improve employee retention and commitment to company goals.
- Tax benefits: Australian legislation offers tax concessions under ESS schemes, allowing employees to defer tax on shares or options until a future event, like the sale of shares. One popular way of deferring the taxing point is to provide an interest free loan to the same value of the employee shares issued which only gets repaid when the shares are sold. The other way of deferring the taxing point is by being able to access the Small Start-up Concessions for companies that have operated for less than 10 years, however these may be hard to access unless you are prepared to offer them to all staff not just key people. In addition, the maximum discount that can be offered on the shares is 15% of market value.
Potential drawbacks
- Issuing shares to employees can dilute the ownership stakes of existing shareholders, including founders and early investors.
- Employees in unlisted companies may find it challenging to sell their shares until the company goes public or is acquired.
- Employers bear the cost of share issuance and may also face challenges in maintaining control as ownership becomes more widely distributed.
- Upfront Tax: If the scheme is not structured to meet the deferred taxing requirements then the employee will be taxed on the amount of the discount on the shares they receive each financial year.
Employee purchases equity
Definition and structure
Employee equity purchase plans allow employees to buy shares in the company, either at a discounted rate or at market value. Employees invest their own money to become shareholders, aligning their financial interests with the company's success. The company may also be willing to offer vendor finance if the employee is unable to obtain their own.
The employee may buy the shares from an existing shareholder in which case the existing shareholder would receive the cash and have a CGT event in relation to the share sale.
Alternatively, the company could issue shares to the employee, in this situation the employee would pay the cash to the company.
Key features
- Employees invest their own money to purchase shares, which gives them an immediate ownership stake.
- Employers may offer shares at a discounted price, making it more affordable for employees to buy in.
- Employees who purchase shares outright have full ownership and voting rights from the point of purchase.
Advantages for employees and employers
- Direct ownership: Employees who buy shares have direct ownership and are immediately entitled to any dividends or other benefits.
- Motivation: Employees who invest their own money may be more motivated to contribute to the company's success as they have skin in the game.
- Raising capital: Issuing new shares for employees to purchase can be a way for companies to raise capital without issuing debt or relying on external investors.
Potential drawbacks
- Unlike employee share schemes where shares are granted, purchasing shares involves a financial commitment, and the risk that the investment could lose value if the company underperforms.
- Employees who purchase shares are generally subject to immediate taxation on any discount they receive and must report dividends as taxable income.
- The value of purchased shares may fluctuate with the market, exposing employees to financial loss, particularly if the company's performance falters.
Tax implications in Australia
When employees purchase shares, any discount they receive is taxed as income, however if they are purchased at market value then no tax issues up-front.
Normal CGT rules apply when the shares get sold.
Which option is better?
The decision to offer employee shares or allow employees to purchase equity depends on many varying circumstances but we generally see the following:
- For start-up companies with a low value who wish to offer equity to the majority staff, an Employee Share Scheme accessing the Start-up Concessions may be most appropriate.
- For more mature companies with a higher value that wish to offer equity to most staff at a discount we generally see Employee Share Scheme’s structured to be eligible for a deferred taxing point may be most appropriate.
- For companies with higher values who wish to offer specific employees shares in the business but not incur a large upfront tax liability for the employee, employee shares issues in conjunction with a loan owing back to the company for the market value of the shares may be most appropriate.
- For more mature companies where the owners are looking to exit over a specific time period, a direct equity sale to key employees may be most appropriate.
- For start-up companies wanting to raise capital the issue of shares in return for cash may be most appropriate.
WLM can help
WLM has extensive experience with assisting Australian businesses on how to best structure their employee share offers.
If you would like assistance with navigating the tax and accounting challenges facing your business or implementing an employee share scheme, reach out to WLM today.