The ‘Taxing’ Matter of Long Term Incentives
August 2010
On the same par with profitability and growth, a primary goal of most company owners is to create a business culture that fosters achievement by key employees. Long-term incentive (LTI) programs are important to recruiting, retaining and motivating vital employees whose skill and knowledge are fundamental to the overall success of the organization. To an increasing extent, executive compensation includes an array of LTIs, including:
- performance unit plans;
- phantom stock
- restricted stock;
- non-qualified stock options;
- incentive stock options; and
- deferred compensation plans
The definition of these “fringe benefits” varies significantly, as does their tax implications.
Performance Unit Plans
A performance unit plan is an award with a value tied to the increase in the financial metrics of a company as defined by a formula specific to a company, is typically vested over a period of three or four years.
While the employee, independent contractor or outside director has no tax liability at the time of grant, cashing out of the unit becomes a taxable event at which time the recipient is liable for ordinary income.
In terms of the company’s tax ramifications, the Financial Accounting Standards Board (FASB) requires anticipated payments to be expensed as compensation during the performance period and no tax deduction is available until executives are paid.
Phantom Stock
Phantom stock is an LTI designed to provide employees, independent contractors or directors with cash payments equivalent to amounts they could receive under an actual stock option or similar program, but without the issuance of actual stock. Based on “phantom” or “simulated” shares, these units may be equivalent to a public company’s fair market value of the stock, or a private organization’s calculated value.
The executive does not have income tax liability at grant or vesting, but is taxed at ordinary income rates upon exercise/payout of the phantom stock unit.
The company’s tax treatment of phantom stock is more complicated. A charge to earnings is made equal to the value plus appreciation, spread over the vesting period; in addition, the tax deduction must be equal to the amount of income recognized by the phantom stock holder.
Restricted stock is generically defined as forfeitable shares of employer stock which become non-forfeitable upon meeting certain terms and conditions. Under this LTI option, shares of the employer’s stock are issued to an employee, independent contractor or director with the recipient paying nothing, a discounted purchase price, or full value for the shares.
Tax is not levied on the executive at issuance; however, the shares are subject to tax once vested. At that time, the holder realizes ordinary income equal to the difference between the stock’s fair market value at vesting and, if applicable, the amount paid by the recipient to purchase the shares.
The company receives a tax deduction for the full value of shares upon vesting, but is required to charge earnings only for the fair market value of the shares at issuance.
Non-qualified Stock Options
Non-qualified stock options (NSOs) are granted by a company and allow an employee, independent contractor or director to purchase shares of the company’s stock in the future at a predetermined purchase price. NSOs are an option that typically vests over time.
There is no tax at either grant or vesting for the receiving executive; however, an NSO is taxed upon exercise. At this time, the holder realizes ordinary income equal to the difference between the stock’s fair market value at exercise and the exercise price. NSOs also are taxed upon sale of the stock; the holder realizes income at sale of the stock equal to the stock’s appreciation after the exercise of the NSO and may be taxed at capital gains rates. Employees can pay taxes through withholding and year-end reconciliation on their tax return.
The combination of tax deductions, fixed charges to earnings and cash inflow, makes an NSO attractive to companies — the tax benefit of the deduction is credited directly to the capital account and the company receives cash inflow from the NSO’s exercise price and from the cash value of the tax deduction.
Incentive Stock Options
Incentive stock options (ISOs) allow an employee to purchase shares of the company’s stock in the future at a predetermined purchase price and on favorable terms for income tax purposes. Available only to employees and not to independent contractors, ISOs may be granted for a term not to exceed 10 years and an exercise price not less than 100 percent of the stock’s fair market value at grant.
No tax at exercise and tax at sale at long-term capital gains rates makes an ISO an appealing option for employees; however, one drawback is the necessity to hold stock at least one year after exercise to satisfy holding period requirements.
For the company, a primary negative feature is the lack of a tax deduction and the limitation of grants to employees only.
Deferred Compensation Plans
Deferred compensation plans (DCPs), which are limited to management and/or highly compensated employees (HCEs, see ¶105 and ¶270 of the Guide), are designed to provide a tax-deferred opportunity in excess of 401(k) limitations; supply supplemental retirement income for executives and allow for tax deferred capital accumulation potential. Monies otherwise payable to executives are withheld by the company until payment upon retirement or other specified future date; voluntary employee deferrals may be augmented by an additional company contribution or match.
Employee deferrals, company contributions and subsequent earnings are taxable to executives when distributed in the future, allowing for the pre-tax buildup of employee accounts.
Deferred compensation is subject to ordinary tax rates when paid out to the employee with the company receiving a tax deduction in the amount of the payment when made to the employee.
Companies considering any specific LTI plan should consult with appropriate experts for design, management, funding, comprehensive requirements and a review of the specific legal and tax consequences.
Motivation and Golden Handcuffs
The bottom line is: the more effective a long-term incentive plan is, the more focused the employees will be on the long-term growth needs of the company and it will be more difficult for key employees to leave their post for other opportunities.