Being Good to Mama—Trustees and your ESOP

A key element of Section 102 ESOP’s is the obligation to use a trustee in order to qualify for certain benefits.   You have to appoint a trustee when you set up your plan.  You have to notify the ITA of the appointment.  You have to submit all option grants to the trustee and shares issued under the ESOP are actually issued to the trustee for benefit of the relevant employee.  And so on and so forth.

All this raises a simple question.

So, like, what’s a trustee?

Let’s start with a very basic definition, courtesy of Investopedia.

A trustee is a person or firm that holds and administers property or assets for the benefit of a third party. A trustee may be appointed for a wide variety of purposes, such as in the case of bankruptcy, for a charity, for a trust fund or for certain types of retirement plans or pensions. Trustees are trusted to make decisions in the beneficiary’s best interests and often have a fiduciary responsibility to the trust beneficiaries.

Very nice. And the ITA thinks I need one…why?

Remember when we talked about audited financial statements, and how the whole thing was because you cannot be trusted?  Well, the ITA also doesn’t trust your employees and officers either.  Don’t feel bad, they don’t trust anyone. Arguably, with some justification.

Right, we should probably leave a discussion of rampant tax evasion and its impact on the Israeli economy and the ITA’s approach to taxpayers for another day.   😉

To explain, imagine you want to set up an option plan. So you call up the ITA and have a conversation with them that goes like this:

You:  Hello, ITA?  This is The Best Startup Ever.  We want to set up an ESOP and grant options to employees.

ITA: Fantastic! (Rubbing its hands together in glee.)  Don’t forget to add the value of the options to the employee’s salary that month and deduct taxes, National Insurance and Health Tax!

You:  What??? What do you mean “the value of the options”?  We have no idea if these will ever be worth anything.  We could be bust within the year!

ITA:  Motek, that is SO not my problem.  You are using options and shares to reward and compensate employees for their hard work?  Well, that makes them compensation. And Mama always gets her share of compensation.

You: But, listen, couldn’t you hold off a bit? Like, if we have an exit and the employees make money from the ESOP, we will report the earnings and pay taxes then?

ITA:  (Rolls it’s eyes).  Of course you will.  Like you told me about the extra NIS 2,000 in cash you earned designing a website for your neighbor?

You: Ummm…yeah…that.  I meant to. I forgot.  I’m really sorry. Seriously, can’t you do something?

ITA:  (sighing heavily).  You are asking me to hold off on taxing this lovely taxable compensation until the employee has actually seen some cash from them, assuming that ever happens?  Well, it’s like the song—you want Mama to be good to you, you gotta be good to Mama. In this case, Mama would feel so much better if she had some sort of guarantee that she is going to get her money, even if the sale is years in the future and the employee has long since moved on to another company.  I need some trust here.

You:  Ahhh…so like a trustee who can hold all of the options and shares in trust and is legally obligated to ensure that all taxes are paid in.

ITA:  Exactly.  And I expect to see the taxes on that website paid in, yesterday.

You: Yes Ma’am.

So how does this work?

In short, think of the trustee as the responsible adult in the option program.  Their job is to ensure that the ITA receives its tax revenues before the employees get their hot little hands on actual shares or proceeds from the sale of shares.

The way this works in practice is that the company formally appoints an ITA-approved trustee as part of setting up their ESOP program.  All option or share grants made under the program are then “deposited” with the trustee.  When shares are issued under the ESOP, be it as an outright grant or because an employee subsequently exercised their options, these shares are actually issued to the trustee, in its name, for benefit of the specific employee. In fact, if the shares are sold, the money goes initially to the trustee, and not the employee.

Taxes are payable once (a) shares or options are released to the employee or (b) the shares are sold, whichever comes first.  At that point, the trustee calculates the taxes due and either collects it from the employee or deducts it from the sale proceeds, as applicable, for submission to the ITA.   So long as the options are still, well, options, employees are generally not going to withdraw them, in particular since your lawyer will have (hopefully) set up your ESOP so that option grants are non-transferrable.  But if an employee does ask to have their options released, or if they have exercised their options and want to have the shares transferred to them, taxes need to be calculated and paid.  Naturally, in the case of a sale, the trustee will transfer the after-tax proceeds to the employee.  They don’t get to just keep it.  J

Trustees also provide option plan setup, administration and management services.  In my company, option issues are frequently run by both our legal counsel and our trustee, with the call to the trustee being made by either myself or legal counsel. Trustees technically are also required to submit annual reports to the ITA on ESOP activities, though apparently that is on hold until the ITA issues instructions as to what is to be reported.  We’ve been waiting 15 years and counting.  Here as well, a discussion to leave for another day.

My thanks to Odelia Pollak, Adv. for her assistance in this article.  Odelia is the CEO of ESOP – EXCELLENCE, which offers trustee and a wide range of other ESOP management services.