The short version
Sooner or later, many business owners find someone they want alongside them for the long haul: the operations manager who runs the floor, the estimator who wins the work, the project manager clients ask for by name. When that person says real ownership matters, not just a bigger paycheck, the owner faces a question with more answers than most people expect. There are five realistic paths: selling the employee shares at appraised value, granting shares as part of pay, granting a right to buy later, paying a cash bonus that tracks the value of shares without any shares changing hands, and restructuring so the employee shares only in growth from here forward. Each one moves different money, taxes different people at different times, and leaves a different relationship behind.
Two rules shape all of them. Ownership cannot be gifted to an employee; the tax code treats it as pay. And an S corporation, the most common structure for a closely held company, allows only one class of ownership, which takes some popular tools off the table. In the worked example below, an owner who sells a 5% stake in a $4,000,000 company on a note keeps about $145,690 after tax over seven years, and an owner who grants the same stake and covers the employee’s tax bill comes out roughly even in cash, with the employee holding identical shares either way. The difference is the price, and choosing between them is less about tax than about what the owner wants the arrangement to say. Before any structure, the more important question is whether the employee is ready to be an owner at all.
Two Rules That Shape Every Path
The first rule surprises most owners. A transfer of ownership to someone who works for the company, made because of that work, is not a gift, however it is described. The tax code expressly excludes transfers from an employer to an employee from the gift exclusion, and the rules for property transferred in connection with services treat the value of the shares as compensation: wages to the employee in the year they are received, subject to income tax and payroll tax, and a deduction for the company in the same amount. The owner’s $15,000,000 lifetime exemption and the $19,000 annual exclusion never come into it. (A child or other relative who works in the business is the exception worth knowing: a transfer driven by the family relationship rather than the job can be a gift, which is a different analysis.) It does not matter whether the owner hands over existing shares or the company issues new ones; when a shareholder transfers stock they own to an employee, the regulations treat it as a contribution to the company followed by a transfer from the company to the employee, and the company still takes the deduction.
The same logic reaches a sale below value. If the employee pays less than the shares are worth, the difference is pay. That is why every path in this article starts with an independent appraisal.
This is not a bad result. In a pass-through company, the deduction lands on the owner’s return at the owner’s rate, while the employee pays tax at a rate that is often lower, and the gap between the two can make a grant cheaper than it looks. The worked example shows how close to even it can come.
The second rule applies to S corporations. An S corporation may have only one class of stock: every share must carry identical rights to distributions and to proceeds if the company is liquidated or sold. If an employee owns 5%, the employee receives 5% of every distribution, including the ones made to cover the owner’s own taxes. Three consequences follow.
Voting and nonvoting shares are allowed. Differences in voting rights alone do not create a second class, so the owner can give up economics without giving up control.
Profits interests are not available. A share of future growth only, granted with no tax, is a partnership tool. An S corporation has to restructure to use it, which is the fifth path below.
The governing documents have to be corporate in style. Whether a company has one class is decided by its governing provisions: its articles, bylaws, operating agreement, and binding agreements among the owners. An LLC that elected S corporation status often still has a single-member operating agreement written in partnership language, with capital accounts, special allocations, or a liquidation waterfall. That language is harmless while there is one owner and can terminate the S election once there are two. It gets rewritten before the employee signs anything.
Your Entity Sets the Menu
The five paths look different depending on how the company is taxed, so the first question is what kind of entity the employee is joining.
An S corporation, or an LLC taxed as one, is the case this article centers on. It allows voting and nonvoting shares, options, and phantom plans, but not profits interests, and everything runs through the one-class rule.
An LLC taxed as a partnership has the most flexibility. It can grant a profits interest directly, and its operating agreement can divide profit and sale proceeds in almost any way the owners agree to. The trade is the employee’s tax status: a partner is not an employee for tax purposes, so the employee stops receiving a W-2, generally pays self-employment tax on a share of profit, and receives any fixed pay as a guaranteed payment.
A C corporation can issue several classes of stock, and stock issued for services can count toward the qualified small business stock exclusion if the company qualifies. (Incentive stock options are not limited to C corporations: an S corporation can grant them too, but rarely does, because the company gets no deduction on an option that keeps its incentive treatment.) The cost is the second layer of tax on anything distributed, which our article on choosing an LLC, S corporation, or C corporation walks through.
A sole proprietorship or single-member LLC has no ownership to share until it changes form. Admitting a second owner to a single-member LLC turns it into a partnership for tax purposes, unless it has elected to be taxed as a corporation, which is sometimes the right answer and sometimes an expensive surprise.
The Five Paths
A buy-in at appraised value (a direct sale of shares)
The employee buys nonvoting shares at the price an independent appraiser sets. The owner recognizes long-term capital gain on the price above the basis in the shares sold, generally without the 3.8% net investment income tax for an owner who actively runs the business, and the employee owes nothing on the purchase. If the shares come with vesting, such as a company right to buy them back at cost if the employee leaves within a few years, the Section 83(b) election described under the next path matters here too: filed within 30 days of the purchase, it reports no income when the price equals the appraised value, and it keeps later growth from being taxed as wages when the shares vest. There are four ways to pay. The owner can carry a note, which must charge at least the interest rate the IRS publishes each month, and report the gain as principal arrives. The employee can borrow from a bank, which pays the owner at closing but often asks for the owner’s or the company’s guarantee. The company can pay the employee bonuses that go toward buying shares, which turns some of the owner’s ordinary income into capital gain along the way. Or the company can borrow to buy back part of the owner’s shares, which reduces the company’s value enough that the employee buys in for much less. (When the owner is the only shareholder, that buyback is taxed as a distribution rather than a sale, which for an S corporation that was never a C corporation is usually tax-free up to the owner’s basis.) The installment rules for a note are covered in our article on installment sales and earnouts.
Ownership as part of pay (a stock grant or restricted stock)
The company grants shares as compensation, outright or subject to vesting. The employee is taxed on their appraised value as wages, and the company deducts the same amount. With vesting, the employee can file a Section 83(b) election within 30 days of receiving the shares to be taxed on today’s value rather than on the value at each vesting date, so later growth becomes capital gain. The deadline has no extensions, and tax paid under the election is not refunded if the shares are later forfeited. Without the election, an S corporation does not treat the employee as a shareholder until the shares vest, and anything paid on the unvested shares is taxed as more pay.
A right to buy later (stock options)
The company grants an option to buy shares at today’s appraised price for a set number of years. Nothing is taxed at grant. When the employee exercises, the difference between the price and the value then is wages, and the company deducts the same amount. The price needs to be at least fair market value at grant to keep the option outside the deferred compensation rules, so this path needs an appraisal that meets that standard. Options issued to employees for services do not create a second class of stock if they cannot be transferred, are not excessive for the services, and have no readily ascertainable value when granted. Until exercise, the employee is not an owner: no vote, no distributions, no K-1. For benefits and retirement plan testing, though, shares under option count as owned, as described below.
Phantom ownership (phantom stock and SARs)
A written plan promises cash equal to what a set percentage of the company would earn or be worth, paid at set events such as a sale or a departure. No shares change hands. Payments are wages to the employee and deductible when paid (payroll tax can apply earlier, once the benefit vests), the plan has to be designed around the deferred compensation rules, and as long as it is unfunded, unsecured, and carries no vote, it does not disturb an S election. A plan that pays when the employee leaves or retires can also be a retirement plan under the federal law that governs employee benefits (ERISA); one that is unfunded and limited to a small group of key managers usually fits the top-hat exemption from most of that law, which still requires a short statement filed with the Department of Labor within 120 days of adoption. A common variant, the stock appreciation right, pays only the growth in value after the grant date. When the company sells, a buyer will usually treat what the plan owes as debt and subtract it from the price. It is useful as a bridge while documents are finished, or as a top-up on real ownership. An employee who asked to be an owner will usually know the difference.
A share of growth only (a profits interest)
A profits interest gives the employee a share of profit and growth from the grant date forward, with no share of the value already built, no cash outlay, and no tax at grant if it fits the IRS safe harbor. A partnership can grant one directly. An S corporation has to reorganize first, usually by forming a holding company above the operating business through what is called an F reorganization, and then admitting the employee to an operating company that becomes a partnership. The holding company keeps the S election; the operating company files a partnership return, and the employee becomes a partner with all that implies. It costs more to set up and to run every year, and it happens to be the same structure many buyers ask S corporation sellers to put in place before an acquisition, as our article on asset sales and stock sales explains.
Where an ESOP fits
Employee stock ownership plans belong in a different conversation. An ESOP is a retirement plan that buys shares for the benefit of every eligible employee, and it can be a powerful way for an owner to exit, as our article on selling to an ESOP describes. It cannot be built to reward one or two people.
Five paths to employee ownership
Buy-in at appraised value
The owner is paid
The employee buys nonvoting shares with savings, a bank loan, bonuses, or a note the owner carries. Capital gain to the owner; no tax to the employee on the purchase.
Ownership as part of pay
The company deducts it
Shares granted outright or with vesting. Wages to the employee at appraised value when the shares vest, or at grant with an 83(b) election; a matching deduction for the company.
A right to buy later
An owner after exercise
An option at today’s appraised price. No tax at grant; wages to the employee on the growth at exercise.
Phantom ownership
Cash, no shares
A bonus plan that pays as if the employee owned a stake. Ordinary income when paid; no vote and no K-1.
A share of growth only
Takes a restructure
A profits interest from a partnership, or from an S corporation after an F reorganization. No tax at grant inside the safe harbor; higher cost to run.
One Appraisal Serves Every Path
Every path depends on a number: the price under a buy-in, the taxable amount under a grant, the exercise price of an option, the formula in a phantom plan. The same independent appraisal sets all of them.
The appraisal values what the employee actually receives: a minority, nonvoting interest in a private company. That interest is worth less than its share of the whole, because its owner cannot control the company or sell the interest easily, and appraisers apply discounts for both. The discount works in the employee’s favor: it lowers the employee’s price under a buy-in and tax bill under a grant, and none of it is treated as pay as long as the appraisal is real and independent. Our article on how a business is valued for sale explains why that value can sit well below what an outside buyer would pay for the whole company.
Appraisals age. A grant or a sale in a later year needs a current value, and options need one that meets the deferred compensation standard at each grant date. Many owners plan for an annual update once an employee is in the ownership group, because the buy-sell agreement and any future purchases will run off the same number.
A Worked Example: Selling or Granting 5% of a Machine Shop
A machine shop outside San Antonio is organized as an S corporation and owned entirely by its founder, who is married. His operations manager has run the shop floor for nine years and has asked about ownership. The company recapitalizes into voting and nonvoting shares, and an appraiser values the whole company at $4,000,000. A 5% nonvoting stake is $200,000 of that value; after a combined 25% discount for minority interest and lack of marketability, it appraises at $150,000. The owner’s basis in the shares that would change hands is $40,000.
The example uses illustrative flat federal rates. The owner pays 35% on ordinary income, 20% on long-term capital gain (the 2026 rate for joint filers with taxable income above $613,700), and the 3.8% net investment income tax on interest. His income is high enough that every deduction in the example stays within the 35% bracket. His company has a large enough payroll that his 20% qualified business income deduction is not limited by wages, so every dollar the company deducts also trims that deduction by 20 cents. The manager is married, earns a $190,000 salary that is already above the $184,500 Social Security wage base, and pays 22% on his next $53,600 of income and 24% above that: after the $32,200 standard deduction, his salary leaves $157,800 of taxable income, $53,600 short of the top of the 22% bracket. He also pays the 1.45% Medicare tax and the 0.9% additional Medicare tax on his household’s wages above $250,000; his spouse has no wages.
Selling the stake on a note. The manager buys the shares for $150,000 with a seven-year note at the October 2026 mid-term rate of 4.61%, paying $25,558 a year. Over seven years he pays $178,905, of which $28,905 is interest. The owner’s gain is $110,000, taxed at 20% as principal arrives, $22,000 in all, and he pays 38.8% on the interest, about $11,215. Over the seven years, before counting the time value of money, he keeps about $145,690.
Granting the stake with a bonus for the tax. Instead, the company grants the same shares outright in December. The manager has $150,000 of wages and no cash to show for them. His tax on the shares alone would be about $37,913: $34,928 of income tax, $2,175 of Medicare tax, and $810 of additional Medicare tax. A bonus that covers the tax on the shares and on the bonus itself comes to $51,477. The company also pays $2,921 of Medicare tax as the employer, so its cash outlay is $54,398, and its deduction is $204,398: the shares, the bonus, and the employer tax. Because the grant comes in December, almost all of that year’s deduction lands on the owner’s return, since an S corporation’s income and deductions are allocated by shares owned each day. At a flat 35%, the deduction would save him $71,539. Because it also shrinks his qualified business income deduction, it saves him $57,231, which more than covers the company’s $54,398. He comes out about $2,833 ahead in cash.
What the comparison shows. The manager ends up with the same shares either way, with the same $150,000 basis: the price he paid in one case, the wages he was taxed on in the other. The owner ends up about $142,857 apart between the two, which is, in round terms, the price. A grant is close to free in cash for an owner whose deduction is worth his top rate, but it is not free: he gave away 5% of the company and its future distributions, and he collected nothing for it. Which one fits is less a tax question than a question about what the owner wants the arrangement to mean, and whether the employee has some of his own money in it.
Two cautions belong with the numbers. The first is on the owner’s side. For an owner with less income than this one, a deduction this size can reach into a lower bracket. Above the qualified business income thresholds, when the wage limit binds, the extra wages raise that limit, so the owner’s qualified business income deduction can rise rather than shrink. The real answer comes from a projection with the owner’s actual income, not flat rates. The second is on the employee’s side: the payroll tax depends on what else the employee earns that year, which is why the gross-up is calculated last.
Is the Employee Ready to Be an Owner?
People who have watched employee buy-ins go well and go badly tend to agree on one thing: the structure matters less than the person. Ownership is not a reward for doing a job well. It is a different relationship, with different obligations, and it is much harder to unwind than employment. A few questions are worth answering honestly before choosing a path, ideally with the employee in the room for the later ones.
Does the employee create value, or perform a job well? Owners are the people whose presence makes the business worth more and whose departure would make it worth less: they grow revenue, protect margins, or reduce risk over years, not months.
Would the employee be expensive or slow to replace? Client relationships, licenses, technical depth, and the trust of the rest of the team are what justify sharing ownership rather than paying a bigger bonus.
Can the employee read the financial statements, and is the owner willing to share them? Owners generally have a legal right to see the books. Once the employee owns shares, the profit and loss statement, and the owner’s own pay, are no longer private.
Does the employee understand pass-through tax? An owner owes tax on a share of profit whether or not cash is distributed, and estimated payments and a K-1 that arrives in March come with the shares.
Is the employee prepared to put in personal money, and to contribute more if the company needs it? The part of a purchase the employee funds is what makes the commitment real, and ownership means sharing the downside as well as the upside.
Does the employee understand that this is harder to leave than a job? Quitting a job takes two weeks. Leaving an ownership position is a negotiated transaction with a price and terms, written down in advance in the buy-sell agreement.
Does the employee’s household understand? In Texas and the other community property states, shares acquired during a marriage are generally community property, so the employee’s spouse has an interest in them, will usually need to sign the ownership documents, and should understand what they say.
Track record answers these questions better than conversation does. An employee who has already priced a large bid, handled a quality failure with an important customer, or steered a crew through a slow quarter, with the company’s money in mind each time, has answered most of them before anyone asks. The exit terms deserve the same honesty. If the price and payment terms in the buy-sell agreement become the main thing keeping the employee in place, the arrangement is working against the relationship it was meant to build, however clean the documents are.
Three Decisions That Pick the Path
Once the answer on readiness is yes, three decisions narrow the five paths quickly.
Does the owner want cash out of this, or is the point to get the employee to the table? If cash matters, the buy-in fits, with the company funding it through a redemption if the owner wants liquidity and the company can borrow. If the point is the employee, ownership as part of pay fits, or a share of growth only if that idea appeals.
How soon should the employee be an owner? If now, a buy-in or a grant. If after a proving period, an option with a locked price, or a phantom plan as a bridge.
How much say does the employee get? Every path can be built without a vote, and voting rights can be added later. If the owner wants the employee at the table without giving up control, a written advisory role in the operating agreement or bylaws can do that.
Many owners end up combining paths: a modest grant now, so the employee is an owner from day one, and a defined right to buy more at appraised value each year, funded by the employee’s savings, bonuses, or a note the owner carries.
Before Anything Is Signed
A handful of items apply whichever path is chosen, and most of them happen once and serve every future owner, not just the first one. Until they exist, nothing should be promised, in writing or in conversation; a casual promise of equity can create obligations before the terms are set.
The appraisal. An independent valuation of a nonvoting minority interest, from a valuation professional, sets the price, the taxable amount, or the exercise price, and documents the discount.
The governing documents. Corporate-style terms only for an S corporation, voting and nonvoting shares, and a clear statement of whether owners can be asked to put in more capital, written so the owner keeps control over major decisions.
The buy-sell agreement. What happens if the employee quits, is terminated, dies, becomes disabled, or divorces: the price formula or appraisal trigger, different prices for a good departure and a bad one, payment terms, transfer restrictions, how a repurchase is funded, and, for an S corporation, a bar on transfers to anyone who could not be an S corporation shareholder. In Texas this matters more than in many states: the Texas Supreme Court declined in 2014 to recognize a common-law claim for minority shareholder oppression, which leaves the agreement as a minority owner’s primary protection. Our article on buy-sell agreements after Connelly covers how these agreements are built and funded.
The spouse. The employee’s spouse signs, because of community property, and someone confirms the spouse is a U.S. citizen or resident. A nonresident alien spouse with a community interest in S corporation shares is an ineligible shareholder, and that alone can end the S election for the whole company.
Payroll that stays clean. In a corporation, the employee remains a W-2 employee at a reasonable salary, and so does the owner; an S corporation owner who works in the business has to be paid a defensible wage before taking distributions, as our article on reasonable compensation explains. Under a profits interest, the employee becomes a partner instead and stops receiving a W-2, as described above.
Benefits that change above 2%. In an S corporation, an owner of more than 2% on any day of the year, counting shares held by close family and shares under option, is treated like a partner for many fringe benefits for that entire year. Company-paid health insurance becomes taxable wages for income tax, though not for Social Security or Medicare tax when it is paid under a plan for employees. The premiums are usually deductible on the owner’s own return, which can leave the income tax roughly where it was. The deduction requires the company to pay or reimburse the premiums and report them on the W-2, and it is lost for any month the owner was eligible for a subsidized plan through another job or a spouse’s employer. Pretax participation in a cafeteria plan ends, along with the flexible spending accounts that run through it. A 5% stake crosses that line even when it arrives in December, and the whole year’s premiums become wages.
The retirement plan. Ownership changes how the company’s retirement plan is tested. An owner of more than 5%, counting shares held by close family and shares under option, is a highly compensated employee whatever the pay. Unless the plan uses a safe harbor design, its annual testing limits what highly compensated employees can defer, as a share of pay, based on what everyone else defers. An owner of more than 1% who earns more than $150,000 is a key employee, as the manager in the example becomes. When key employees hold more than 60% of a plan’s accounts, the plan is top-heavy, and the other participants are owed a minimum employer contribution, usually 3% of pay. A safe harbor 401(k), funded only by employee deferrals and the safe harbor contributions, is exempt from the top-heavy rule. A plan funded by employee deferrals alone is not, and neither is one that adds a profit-sharing contribution, so the plan’s administrator runs the tests before the shares move.
A written distribution policy. Every distribution pro rata, including the ones made to cover owners’ taxes, with a year-end true-up, and no personal expenses running through the company.
The pool. How much of the company the owner is willing to share over time, and whether other key people may join later under written criteria.
A securities check. Selling or granting shares to an employee is a securities transaction. For a private company an exemption usually covers it, but the attorney should confirm which one.
The numbers. The owner’s after-tax proceeds, the employee’s after-tax cost, and the company’s cash flow, modeled for each finalist path.
The calendar. A mid-year admission splits the year’s income by shares owned each day, and a vesting grant starts a 30-day clock for the election.
How We Think About It
We lean toward settling whether the employee is ready to be an owner before choosing how. Ownership is a different relationship from employment, with obligations on both sides, and it is far harder to undo; the best structure cannot fix the wrong owner, and an employee who is ready makes almost any of these paths work.
When an employee has asked for real ownership, we lean toward real ownership, with a phantom plan as a bridge or a top-up rather than the answer. We also lean toward some of the employee’s own money in the deal, even if bonuses fund most of it. A grant can make sense on its own, as the example shows, but a stake the employee helped pay for usually changes how the employee thinks about it.
We lean toward a common starting point, adjusted to the people and the numbers: an appraisal and the document work first, then a modest grant of nonvoting shares with vesting, an 83(b) election, and a cash bonus to cover the tax, and a defined right to buy more at appraised value each year. That gives the employee ownership now, gets the owner paid for the larger share over time, keeps every vote with the owner, and leaves every larger door open. The choice among the paths is modeled on the owner’s after-tax proceeds, the employee’s after-tax cost, and the company’s cash flow, never set by a rule of thumb, and it is made alongside the company’s CPA and attorney, who draft the documents and file the returns.
Common Questions
Can I gift part of my business to an employee?
Not when the reason is the work. A transfer of ownership to someone who works for the company is treated as compensation, not a gift: the value is wages to the employee, subject to income tax and payroll tax, and the company deducts the same amount. That is true whether the owner transfers existing shares or the company issues new ones, and it is also true of the difference when an employee pays less than the appraised value. The owner’s lifetime gift exemption and annual exclusion do not apply. A family member who works in the business can be different, when the transfer is driven by the relationship rather than the job.
How is an employee taxed on ownership received as pay?
Shares received as pay are taxed as wages at their fair market value when they are received, or, if they vest over time, at their value on each vesting date. With vesting, the employee can instead file a Section 83(b) election within 30 days of receiving the shares, to be taxed on today’s value, so later growth is capital gain when the shares are sold. Shares bought at appraised value are not taxed at purchase, and an option is taxed when it is exercised, on the difference between the price and the value then.
Can an S corporation give an employee a profits interest?
Not directly. A profits interest is a partnership tool, and an S corporation can have only one class of stock, so every share must share equally in distributions and proceeds. An S corporation can grant regular shares, options, or a phantom plan, or it can restructure, usually by forming a holding company and moving the operating business into an entity that becomes a partnership once the employee joins, so the employee can receive a profits interest there.
Should a key employee pay for ownership?
There is no rule, and a grant can be close to free in cash for an owner whose deduction is worth a high-bracket rate. Many owners still want some of the employee’s own money in the deal, because the part the employee pays for is what makes the commitment real. A common middle path is a modest grant now, with the employee buying more over time at appraised value with savings, bonuses, or a note the owner carries.