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Inventive Incentives: Beyond Wages and Bonuses By Deborah DiVerdi Carlson, Esquire, Posternak Blankstein & Lund LLP
"Reward and retain." 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 through a system of annual bonuses. But for many companies, payment of 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. Moreover, once a bonus is paid, it no longer serves as an effective retention tool.
According to the results of a survey of 2600 hiring managers by CareerBuilder.com, business owners in 2007 will become more competitive in recruitment and retention efforts. The competition for new hirers will force business owners who do not 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. STOCK APPRECIATION RIGHTS A stock appreciation right (SAR) gives an employee the right to receive the value of the appreciation in the underlying stock that occurs from the date the right is granted up to the date of payment. Thus, 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; she only receives the right to payment attributable to the appreciation in the stock upon the happening of a contractual payment trigger. 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 her employment, she will forfeit some or all of her 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 an SAR, 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. 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. Typical restrictions include restrictions on the sale of such shares and restrictions 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 she 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 that the IRS imposes on qualified plans and therefore 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 which is 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 specially 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, t he employee will be subject to tax on any realized gain only when she 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%. 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 is an effective way to allow 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 on-going administration. The savings to employers from reduced employer-paid FICA and FUTA taxes usually wholly offsets these administrative costs. Therefore, a cafeteria plan is a low-cost tool that benefits employees. Such plans can be used as both a recruitment and a retention tool. 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 LOANS 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 her compensation from commissions. The loan can be used to help support the employee while she builds up her 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.
*** When it comes to compensation, one size does not fit all. The foregoing tools represent available methods that can be used to reward employees, but also to retain those employees because of the deferred reward inherent in each compensation method. Business owners must assess their own employees and determine what compensation packages will effectively reward and retain their highest performers, and then put those packages in place. Otherwise, they will find themselves wasting precious time and energy recruiting and training new employees. Before implementing any compensation tool, careful consideration should be made to comply with all of the tax rules applicable to such compensation so that the desired tax effect to both employer and employee is achieved. |
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