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How employee ownership can work at widely held banks

Part 3: Simpler in some ways, but tax impact must be weighed

How employee ownership can work at widely held banks

This blog is the third in my series discussing the importance of attracting and retaining key personnel in our community banks. The first dealt with whether employee ownership is a “good thing” and, assuming that it was, specifically discussed the use of employee stock ownership plans and 401k employee stock ownership plans to accomplish employee ownership. The second blog addressed an all-too-common scenario where a closely-held bank that wants to provide ownership to its employees also does not want to lose majority control over ownership. That blog provided a couple of alternatives.

This final blog of the series will deal with the use of employee ownership in other than “closely held” banks. Because approximately one-third of the banks in the country have converted to Subchapter S, the remaining two-thirds of the banks in the country are not particularly “closely-held,” by definition.

Broad ownership broadens choices

The typical, widely held community bank may have a couple of hundred shareholders, with the board generally controlling a minority position of between 20% and 40% of the stock.

For these boards, if the goal is to attract and retain key personnel and the method is to invite employee ownership, then the alternatives available to the board are many. They can utilize the ESOP/KSOP route addressed in the first blog; they can utilize the stock appreciation rights and phantom stock (addressed in the second blog), and they can also utilize restricted stock and stock options.

If the board is not worried about ownership dilution, because they are not in a controlling position, restricted stock or stock options may be perfect alternatives.

Many more community banks are moving toward restricted stock because of its significant flexibility and incenting powers. Restricted stock is simply a stock grant conditioned upon whatever restrictions the board wishes to put on the grant. Once the condition is met, the employee receives the stock.

Typical restrictions include the passage of time (i.e., you actually get the stock when you have been with the company a certain length of time) and financial performance (e.g., the employee gets the stock when the company has returned a 12% ROE for eight consecutive quarters). Restricted stock is a non-qualified plan, so the community bank’s board can put whatever restrictions on the stock that it deems appropriate, as long as the employee will accept it.

As a short-term incentive, the bank can even provide that the employee gets the dividend on their restricted stock.

Keep in mind that a community bank gets what it incents. If the restricted stock is tied to pristine asset quality or higher earnings, that is what you will get by providing the employee with restricted stock.

Handling Uncle Sam and his share

Tax treatment of restricted stock should be considered. The employee is not taxed on the stock until the employee actually receives the rights to the stock. The downside of this is that while the stock may be worth $10 per share on the date of grant, it may be worth $50 per share on the date the restrictions come off. The employee would then be taxed on the value of the stock at the time he or she receives the right—i.e., $50 per share.

Wouldn’t the employee rather be taxed on the value of the stock when it is granted? 

Most employees would. That is why an employee can make what is known as a “Section 83(b) election.” 

Derived from Internal Revenue Code Section 83(b), this election allows the employee to be taxed on the value of the stock at the date of grant, rather than the date on which the restrictions are lifted. The employee is not taxed further on the value of the stock until he or she sells it.

And from the company’s perspective, if the employee makes an 83(b) election and elects to be taxed on the value of the stock at the time of grant, then the company receives a similar compensation expense deduction.

A special note for Subchapter S community banks potentially offering restricted stocks: Be careful not to create anything that would appear to be a second class of stock. There are some technical rules that go along with that beyond the scope of this blog, but just keep it in mind.

Taking a fresh look at stock options

Stock options are a little more familiar to most community banks.

A stock option simply gives the employee the right to purchase a share or many shares of stock in the future at today’s price.

If a qualified stock option (i.e., IRS tax-benefitted option) is granted when the value of the stock is $10 per share, then the employee pays no tax at the time of the grant and pays no tax at the date of exercise. No tax is imposed until the employee sells the stock, at which point the employee pays capital gains on the increase in value of the stock, provided the employee has held the stock for a year after exercise of the option.

There are a number of additional criteria in order for a stock option to be “tax-benefitted,” including grant of the options at fair market value. Although stock options remain popular, these requirements and accounting changes a few years ago resulted in stock options becoming more complicated and expensive to utilize.

Despite their differences, either restricted stock or stock options provide for employee ownership, which is a good thing because your employees will then think like owners.

Jeff Gerrish

Jeff Gerrish is chairman of the board of Gerrish McCreary Smith Consultants, LLC, and a member of the Memphis-based law firm of Gerrish McCreary Smith, PC, Attorneys. He frequently contributes to Banking Exchange and frequently speaks at industry events.
Gerrish formerly served as regional counsel for the FDIC’s Memphis regional office and with the FDIC in Washington, D.C., where he had nationwide responsibility for litigation against directors of failed banks. Since the firm’s formation in 1988, Gerrish McCreary Smith has assisted over 1,500 community banks in all 50 states across the nation with matters such as strategic planning, mergers and acquisitions, common stock private placements, holding company formation and reorganization, and a wide variety of regulatory matters. Jeff Gerrish can be contacted at jgerrish@gerrish.com.

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