The golden rule of taxation: Always consult experts. ~ Alex Freeburg, Owner, Freeburg Law
In this article, thirteen industry leaders, including founders and Chief Officers, share their insights on structuring compensation packages for startups and navigating tax-related challenges. From structuring salaries based on tax classifications to ensuring compliance with tax regulations, these experts provide a comprehensive guide for startups. Dive into their valuable advice to make the most of your compensation planning.
- Structure Salaries Based on Tax Classifications
- Leverage Tax Breaks for Student Loans
- Offer Ample PTO and Understand Tax Implications
- Balance Equity and Cash
- Educate Employees on Equity
- Implement Retirement Savings Plans
- Ensure Transparency in Compensation Packages
- Consider Non-Monetary Benefits
- Adopt a Modular Approach
- Balance Immediate and Deferred Compensation
- Institute Employee Stock Purchase Plans
- Hire Experts for Compensation Planning
- Ensure Compliance with Tax Regulations
Structure Salaries Based on Tax Classifications
When structuring compensation packages for your employees, aim the base-salary brackets towards the least taxable income. This is so they pay the minimum amount of tax and get the maximum take-home pay after tax deductions. Keep in mind the seven federal tax classifications so you can structure your employee salaries based on them.
Leverage Tax Breaks for Student Loans
Consider ways you can use tax breaks to your advantage so both you and your employees can get the most out of your compensation plans. One of the best options right now can help the millions of Americans now facing student loan interest again after a long period of governmental relief—student loan employer contributions.
Employers can contribute as much as $5,250 every year toward an employee’s student loan debts without incurring payroll taxes on the employer’s end and income taxes on the employee’s. Without paying taxes on that money, it stretches much further than it normally would to provide a welcome relief for your teammates.
Since most startups hire a load of up-and-coming talent, they’re likely fresh enough in their careers that their student debt burden is still high.
Offer Ample PTO and Understand Tax Implications
Ample vacation and other paid time-off is a huge plus for employees, especially in startups where they may regularly face high-pressure situations and longer than usual work weeks. Offer as much PTO as possible and work to build out that program as soon as you can—it’s the best way to hold on to the great talent you’re developing over the long term.
Beware of the structure of your PTO payouts, because your accounting method impacts your tax obligations. If you use a cash method, you only deduct taxes on the amount paid out to employees during the tax year itself, while with the accrual method, you can deduct future vacation pay before you actually make the payment if a few requirements are met.
An employee’s right to the PTO payment must be unconditional, fixed, and they’ve completed the work on which it was based.
Balance Equity and Cash
As a startup leader, it’s essential to consider equity ownership when structuring compensation packages for employees. Offering equity aligns their interests with the company’s success, fostering motivation to contribute to our growth.
However, striking the right balance between cash and equity is crucial to attract and retain talent. An over-reliance on equity may discourage candidates seeking immediate financial stability. Thus, it’s wise to provide a combination of competitive base salaries, performance bonuses, and equity options.
For navigating tax-related challenges while designing compensation plans, the importance of consulting with tax professionals or financial advisors specializing in startup compensation cannot be overstated. Their expertise helps structure equity options to minimize tax burdens for both employees and the company.
Educate Employees on Equity
From an employer’s perspective, it can be really hard to convince employees to take on equity compensation because equity-based compensation can be really complex. In my experience with my first startup, both existing and new employees lacked a thorough understanding of equity ownership.
This is especially true in the context of private companies. Unfortunately, offer letters and compensation clauses can be extremely complicated to the point where legal advice may be necessary to fully grasp them. Contract reviews may be costly and time-consuming, which is why so few people actually want them. I’ve also seen employees get taken advantage of by ambiguous terms like clawback clauses.
It’s no longer the case that their tax return was quite straightforward, and that their pay-by-pay income tax withholdings satisfied their annual deposit obligations. To navigate this, I recommend thoroughly discussing and educating your employees first before offering compensation packages.
Implement Retirement Savings Plans
One of the major focuses in our startup was to create a financial future for our employees. A lot of small businesses, startups, or nonprofit organizations just try to grow from one month to another, failing to understand that their teams need to secure their future.
They lose a lot of talent and valuable employees as soon as these employees understand that retirement shouldn’t be neglected. We have created retirement savings plans and strategies for our teams and also for our clients, to make sure they future-proof their golden years.
Ensure Transparency in Compensation Packages
Compensation packages need to be transparent and clear. They should outline exactly why there are differences in compensation, which is usually related to roles, responsibilities, and expected results. As for tax implications, these should be communicated and made clear. For example, bonuses are often subject to much higher tax rates than salaries.
Consider Non-Monetary Benefits
There are so many factors to be considered when assessing a compensation package for employees. In fact, when structuring it, you should not only focus on the salary but also consider non-monetary benefits that will add significant weight to the package as a whole, even if you can’t afford to pay your employees more.
This could be offering medical insurance, which is a huge addition that will be extremely beneficial for employees, or offering wellness programs to support employee mental health and fitness programs for their physical health, or even retirement plans or contributions that will help support employees even after they retire.
These elements are extremely competitive and can make all the difference when comparing packages in your favor.
Adopt a Modular Approach
One of the most neglected but crucial issues for startups when constructing pay packages is “future-proofing.” The compensation structure should be adaptable enough to handle adjustments without requiring a redesign.
Consider a modular approach instead of committing to long-term compensation commitments. Create a base wage structure that is supplemented with performance-based bonuses, equity options, or even milestone-driven incentives. This not only keeps staff motivated but also allows the firm to better manage its financial flow.
When it comes to navigating tax-related challenges, a best practice is to incorporate “tax-efficient equity structures” for employees. One way to make this tax efficient is by offering “vesting schedules” with a “cliff.” This means that employees earn their equity over time, and a certain portion becomes available (vests) after they’ve been with the company for a specific period, known as the cliff.
Balance Immediate and Deferred Compensation
One essential consideration that startups should consider while structuring compensation packages is the balance between immediate and deferred compensation. Startups often have limited funds, and as such, they may not be able to match the salaries offered by established companies. However, they can offer company equity as part of the compensation package. While this presents potential for higher future value, it also carries risk as the business may not succeed.
When designing compensation plans, it’s critical to remain updated on the latest tax laws and regulations to prevent unnecessary liabilities. Collaborating with a qualified tax adviser who can provide accurate, up-to-date advice is recommended. This ensures the business remains tax-compliant while maximizing the effectiveness and attractiveness of the compensation plan.
Institute Employee Stock Purchase Plans
Consider instituting Employee Stock Purchase Plans (ESPPs) to address tax-related challenges when designing compensation plans. ESPPs allow employees to buy company stock at a discount, generally through payroll deductions. These programs can give substantial tax benefits to both companies and employees.
Employees frequently profit from the ability to purchase company stock at a lower price, which may result in capital gains when the shares are sold. ESPPs can be an effective tool for firms to incentivize employee ownership without incurring immediate tax obligations.
Consult with financial and legal specialists to create an ESPP that is tax-compliant and consistent with the financial plan of your startup. Properly constructed ESPPs can benefit both entrepreneurs and employees.
Hire Experts for Compensation Planning
Hire an expert to structure an optimal plan while saving resources and ensuring everything is done right. You have several options to choose from. You can hire the services of a compensation planning and design company, or you can recruit a talent management company to provide the necessary expertise.
Other options include signing up for an employee compensation management software or tool, or availing of full-service consulting. With streamlined calculations backing up a well-balanced compensation philosophy, these experienced teams can help you create error-free compensation structures. More importantly, these compensation plans will adhere to the tax matrix and ensure legal compliance.
Ensure Compliance with Tax Regulations
Ensuring that you are fully in line with all state and federal regulations is not a box to merely check off—it’s foundational. Non-compliance can unravel even the most promising ventures, leading to penalties and legal complications that can be very challenging to navigate.
The golden rule of taxation: Always consult experts. A tax advisor or legal counsel can help you lay out a compensation structure that not only benefits your employees and the company but also stands up to legal scrutiny. This comes with an upfront cost, but it’s essentially an insurance policy against future, potentially costlier, legal predicaments.