Learn the advantages and considerations of Loan Funded Share Plans (LFSPs) as an alternative to employee options, providing tax benefits and alignment with shareholder interests.
Asides from ESOPs, companies might also consider alternative arrangements such as Loan Funded Share Plans (LFSP) to reward senior employees with equity. LFSPs offer a tax-efficient solution and enable staff to participate in the capital growth of the company without the complications of traditional options (particularly for founders). This article explores the structure and benefits of LFSPs, while also highlighting potential pitfalls and considerations.
What’s a Loan Funded Share Plan?
LFSPs involve the employer providing an interest-free limited recourse loan to employees, allowing them to acquire shares in the company at market value. The limited recourse feature protects employees from downside risks if the share value falls below the outstanding loan balance. Typically, the shares acquired through LFSPs are held in a trust operated by the employer until vesting. Dividends received from the shares or salary sacrificed amounts are often utilized to pay down the loan.
Advantages of Loan Funded Share Plans
Tax Benefits: Unlike options, LFSPs do not trigger a tax liability at vesting. Instead, employees only incur tax obligations when they sell their shares. The gain made on the shares is subject to capital gains tax, with only 50% of the gain being taxable if the shares are held for at least 12 months. This is particularly important for founders, whom are often not eligible for the startup-concessions afforded to startup ESOP plans when they hold more than 10% of the cap table.
Reduced Reporting Obligations: LFSPs are not subject to the reporting and disclosure requirements imposed by the Employee Share Scheme Rules (ESS Rules), providing more administrative ease for employers.
Tax Efficiency for Employees: LFSPs offer employees the advantage of being taxed on capital gains rather than ordinary income, resulting in potential tax savings. This structure aligns employee interests with those of shareholders, as any increase in share price generates a net gain for the employee after loan repayment and dividends.
Considerations and Potential Pitfalls
Employee Tax Risks: Acquiring shares at market value is crucial to ensure employees are only taxed upon disposal. Discounted share acquisitions may trigger tax liabilities and subject employers to reporting and disclosure obligations under the ESS Rules. While independent valuations are not compulsory, the valuation basis should be defensible if challenged by tax authorities. Additionally, caution must be exercised when providing loans to employees who are already shareholders to avoid potential deemed dividends under Division 7A.
Employer Tax Traps: Employers must navigate the application of Fringe Benefits Tax (FBT) rules when providing interest-free loans. To avoid FBT liability, the loan must meet the conditions of the ‘otherwise deductible’ rule, demonstrating that the loan is used for income-producing purposes. Furthermore, loans provided to associates of employees may not qualify for the ‘otherwise deductible’ rule, resulting in FBT obligations. Structuring arrangements to address a potential fall in share value and loan settlement is vital to avoid FBT liabilities arising from debt waivers.
Compliance with Regulatory Requirements: Employers must consider the application of Corporations Law, ensuring compliance with fundraising rules and evaluating exemptions from the disclosure document requirement. Additionally, financial assistance rules may come into play when an employer provides loans to employees, necessitating further analysis and compliance.
Current Landscape and Future Trends
Loan Funded Share Plans have gained traction as an alternative employee equity arrangement, with an increasing number of companies adopting this structure. While LFSPs offer advantages such as tax efficiency and alignment with shareholder interests, they may be more complex to understand and administer compared to traditional options.
Some institutional investors and regulatory frameworks in certain countries may not fully support LFSPs. Nevertheless, limited recourse loan plans are expected to remain widely used by unlisted companies, provided they navigate potential tax implications under income tax legislation.
While LFSPs may be more complex to understand and administer compared to traditional options, they continue to be widely used by unlisted companies. Overall, LFSPs offer a compelling alternative for companies looking to reward employees with equity while navigating tax and regulatory considerations. Contact Fullstack if you need assistance.