New England Biz Law Update
When companies discuss personnel costs, the conversation often turns to designing and implementing compensation tools that will reward and retain skilled and high performing employees.
If a company has significant cash flow, it can reward its key employees with annual bonuses. But for many companies, paying bonuses may not be an option. And for other companies that want to focus on equity-based compensation in order to align the interests of their employees with their shareholders, bonuses are not desirable. Also, once a bonus is paid, it no longer serves as an effective retention tool.
According to the results of a survey of 2,600 hiring managers by CareerBuilder.com, business owners in 2007 will become more competitive in recruitment and retention efforts. The competition for new hires will force businesses that don’t want to lose employees to assess how satisfied their employees are, and to design and implement compensation packages to keep their workforce in place.
According to human resource consultants, employees tend to look for jobs in the early part of the year, so it is critical for business owners to make that assessment now and design systems that will reward and retain their employees. This article will discuss some methods – other than increasing wages and paying annual bonuses – that may be used by companies to reward and retain employees.
When it comes to compensation, one size does not fit all. The compensation tools discussed below can be used to reward employees, but also to retain those employees because of the deferred reward inherent in each compensation method.
Businesses must assess their employees and determine what compensation packages will effectively reward and retain their highest performers, and then put those packages in place. Before implementing any compensation tool, companies have to make every effort to comply with all applicable tax rules to achieve the desired tax effect to both employer and employee.
Stock appreciation rights. A stock appreciation right (SAR) gives an employee the right to receive the value of the appreciation in the underlying stock from the date the right is granted up to the date of exercise. The employee can obtain a benefit from a stock’s growth without actually owning any stock of the employer.
The employee does not receive any rights as a shareholder, such as voting and dividends. He only receives the right to payment attributable to the appreciation in the stock upon exercise, which would equal the current market value less the grant price. The payment is equal to the current market value of the stock at the time of payment, less the value of the stock at the time of grant. This is normally paid out in cash, but could be paid in stock.
Normally, SARs are subject to vesting so that if an employee terminates his employment, he will forfeit some or all of his right to payment for the appreciation in the stock. Payment triggers include a date or dates certain, death of the employee, and the sale of the company.
Phantom stock. Like SARs, phantom stock does not convey any actual ownership in the employer’s stock. A share of phantom stock is a credit in an employee account for an amount equal to the full value of a share of the company’s actual stock. Over time, the account is credited with changes in share value (and dividends and other distributions, if the parties wish).
As is the case with SARs, phantom stock is normally subject to vesting. This is an efficient way to retain an employee who will receive a payment that, like a SAR payment, could be tied to a sale of the company or some other permissible future event or date certain.
Restricted stock. Unlike SARs and phantom stock, restricted stock issued to an employee actually conveys ownership in the employer’s company. Such shares are always subject to some restrictions, such as on the sale of such shares and on the acquisition (in the form of vesting) of such shares.
The employee typically would be given shares or the right to buy shares (at fair market value or at a discount), but cannot take possession of them until some time later when certain requirements have been met (or restrictions have been lifted), such as working for a certain number of years or meeting certain performance goals. If the employee does not meet the requirements for restrictions to lapse, the shares are forfeited.
Stock options. Stock options give an employee the right to buy a certain number of shares of the company at a fixed price, so long as he exercises that right within a set number of years. Companies can grant either non-qualified or incentive stock options.
Non-qualified stock options. Nonqualified stock options (NQSO) are stock options that do not meet specific requirements in the Internal Revenue Code for special tax treatment. A NQSO plan does not have to adhere to many of the restrictions the IRS imposes on qualified plans, which means companies have significant flexibility in designing these plans.
The gain on NQSOs at exercise (difference between exercise price and sale price) is taxed to the employee as ordinary income. The employer receives a tax deduction for the gain received by the employee at exercise.
Discounted NQSOs (those that have an exercise price less than the fair market value of the stock at the time the option is granted) trigger adverse tax consequences to recipient employees. Therefore, discounted NQSOs should not be used as a compensation tool. Only NQSOs issued with an exercise price equal to full fair market value should ever be considered.
Incentive stock options. Incentive stock options (ISO) are structured to qualify for preferential tax treatment for the option holder. If the ISO meets several IRS conditions (for example, the exercise price cannot be less than the fair market value of the stock at the time the option is granted), the holder of the ISO will receive preferential tax treatment.
Although ISOs have more favorable tax treatment than NQSOs, they also require the holder to take on more risk by holding onto the stock for a longer period of time. ISOs can also have an impact on the alternative minimum tax payable by the employee.
Generally, if all conditions are met, the employee will be subject to tax on any realized gain only when he sells the stock. The employer receives no tax deduction from any gain received by the employee.
Employee stock purchase plans. An employee stock purchase plan (ESPP) allows employees to use after-tax payroll deductions to acquire their employer’s stock, usually at a discount of up to 15 percent. The employee can buy stock at a bargain price and defer income tax until the stock is sold.
Generally, through payroll deductions, the employee makes contributions to a stock purchase fund and, at designated points in the year, the employer uses the accumulated money in the fund to purchase stock for the employee. The employee will not owe any taxes when the employer purchases the stock for the employee.
When the employee sells the stock, however, the discount received when the stock was purchased is generally considered additional compensation taxed as ordinary income. The employer is unable to deduct this compensation income.
Cafeteria plans. A cafeteria plan allows employees to use pre-tax wages to pay for expenses they otherwise would have to pay with after-tax wages. The savings can be significant for employees and there is no cost to employers, other than the costs of putting the plan in place and ongoing administration.
The savings to employers from reduced employer-paid FICA and FUTA taxes usually offsets these administrative costs. A cafeteria plan is a low-cost tool that benefits employees. Examples of benefits that can be paid for under a cafeteria plan with pre-tax dollars include accident benefits, medical and dental benefits, adoption assistance, dependent care assistance, and group-term life insurance coverage.
Compensation-related loan. A compensation-related loan is a “below market rate” loan made in connection with the performance of services, directly or indirectly, between an employer and an employee. Generally, compensation-related loans result in additional compensation and a possible interest deduction to the employee equal to the foregone interest.
Compensation-related loans can be used when an employee is expected to receive a large portion of his compensation from commissions. The loan can be used to help support the employee while he builds up his commission income.
The loan can be forgiven over a number of years (with the forgiven portion included in the employee’s income in the year of forgiveness). If the employee leaves without repaying the note, or the entire amount being forgiven, the remaining balance becomes due and payable to the employer.
Deborah DiVerdi Carlson is a partner at Posternak Blankstein & Lund LLP. Her practice focuses primarily on business counseling and transactional work with extensive experience in the creation of, and strategic venturing by companies and individuals in, corporations and limited liability companies. She also counsels purchasers and sellers in private equity financings, mergers and acquisitions and business dispositions. She can be reached at [email protected].
