What You Need to Know About Executive Compensation Plans
For those of you who are looking to offer additional incentive programs for your key executives, here are a few options you may want to consider.
Nonqualified Deferred-Compensation (Supplemental Retirement Plans)These types of plans provide additional retirement benefits to key employees, in addition to or in place of the employer's regular qualified retirement plan.
There is a great deal of flexibility in the design of these types of plans. An employer can decided who can participate; how long the vesting schedule will be; how much they want to contribute; and where the money can be invested.
It is important to keep in mind that the design of these plans is only limited by your imagination. You are free to create almost any vesting schedule, funding level and eligibility requirement you desire.
Employer Instituted PlanEligibility in an employer-instituted plan is usually confined to key executives or technical employees who are difficult to recruit and keep. The value of this type of plan is that the key employees could conceivably exceed the Section 415 limits of the IRC for retirement plan contributions. More importantly, in the case where key employees are limited in their 401k contributions, this plan can be used as a catch-up or make-up plan.
Generally these plans are funded with contributions from the employer. If the employer deducts the contribution, the executive must pay income tax, which is usually a strong disincentive. On the other hand, if the contribution is not immediately taxable to the executive, it is not immediately deductible to the employer.
Once benefits are paid out of the plan to the executive, the employer can deduct them and the executive must pay ordinary income tax on them.
You will have to decide which is best for your company, but I can tell you that I recommend that the employer forgo the deduction until benefits are paid to the executive.
Employee-Option PlanOccasionally there are situations where the employee wants to defer his own salary into the plan. This is rare and usually occurs when the employee has a significantly greater salary than their lifestyle requires. In this situation, the executive is refusing the salary, and they are giving up some of the rights they had to that money. In order to avoid constructive receipt, the employer must hold the money and it must have substantial risk of forfeiture.
Funded and Unfunded PlansThere are also plans where the deferred compensation plan is not funded. Under these types of plans, the employer promises to pay the retirement benefits, but does not establish an account to accumulate the money that will be needed. Rather, they plan on using future earnings. Generally, executives are reluctant to accept these types of plans, because the risk the money may not be there is too great.
ERISA ProvisionsGenerally, employers want to design their plan to avoid the fiduciary, vesting, and reporting and disclosure requirements of ERISA to the maximum extent possible. If a plan is unfunded, it will generally be exempt from ERISA if it is used to reward a select group of management. On the other hand, if you use a mutual fund to formally fund your plan, you will have to meet the reporting requirements of ERISA. However, there are turnkey, off-the-shelf plans from several financial institutions that make it easy to meet this requirement.
Another option is to use a split dollar life insurance plan. The cash value can be used to informally fund the retirement benefits, and there is the added benefit of a tax-free death benefit to the employee's family. The employer can also use the plan to recapture its expenditures and thus have a plan with no net cost. The down side to the life insurance is that some of the employees may be older or uninsurable and this may negatively impact their retirement income relative to a mutual fund.
Restricted StockThis type of plan allows the employer to grant shares in the company to an executive or key employee, and if the grant comes with certain restrictions, the value of the stock is not currently taxable to the executive. Under Code Section 83, the employee can defer taxes until the stock becomes substantially vested. Property is not considered substantially vested if there is substantial risk of forfeiture. A substantial risk of forfeiture usually exists if the employer requires that the employee return the stock if a specified period of service for the employer is not completed.
There is one other significant provision - nontransferability - that must be met before a restricted stock plan will meet IRS standards. Meeting this requirement can be as simple as inscribing the stock certificate with a statement that the owner is not free to sell the shares.
Stock OptionsMost casual readers of business news are aware of the tremendous explosion in the popularity of stock options as part of a compensation package. If your company has plans to go public within a few years, I think you should consider options as part of your compensation package. There are two basic types of plans, nonstatutory and Incentive Stock Options (ISOs).
NonstatutoryOptions to buy stock in the employer company are typically granted to executives as additional compensation at a favorable price, with the hope that the stock price will rise and make the value of the option greater. If the stock price declines the option becomes worthless, but with no risk to the owner. Thus a stock option gives the owner a benefit whose potential value is tied to the fate of company, but with no downside risk.
Nonstatutory stock options can be designed in any manner the employer and executive desire. Typically the option runs for a period such as 10 years, and is granted at a price equal to the fair market value of the stock on the date it is granted.
If the executive is given options at a price that are less than the current market price, the executive must pay ordinary income tax on the value of the option, and the employer gets a corresponding deduction. Once the executive has paid ordinary income tax on the option, he can sell the option in the future and only be subject to capital gains tax (which is much lower). This can be an excellent strategy because the executive could get the options with only a slight value, and later sell them at a terrific gain at favorable rates. Of course this works best when the stock price is expected to rise sharply.
If, on the other hand, the executive is given stock options at the current market value, there is no immediate tax to the executive, nor is there any deduction to the employer. But if the executive later exercises the options, whatever gain he realized as a result of exercising that option will be taxable as ordinary income to the executive, and deductible to the employer.
For example, assume an executive exercises his option to purchase 400 shares at $50 per share, and that the current market value is $100 per share. The executive must pay ordinary income tax on the $20,000 of profit, and the company gets to write that off. If the employee then sells all the stock, he will then treat any further gain or loss as a capital gain or loss.
Incentive Stock OptionsThe incentive stock option (ISO) is the current form of stock option plan eligible for special tax benefits, which are provided by Code Section 422A. Under an ISO plan, the usual tax rules previously discussed do not apply. Instead, for stock purchased under an ISO, an employee will recognize no income for federal tax purposes on the exercise of an ISO, provided that the exercise occurs during employment or within three months after termination and provided the following conditions are met. First, the common stock acquired must be from an option that had been held for a minimum of two years, and the stock acquired must be held for a minimum of one year. If both of these conditions are met, any gain or loss realized by the executive will be treated as long-term capital gain or loss and the employer will not be entitled to any deduction.
If the executive disposes of any of the stock acquired on the exercise of an ISO within either (a) two years of the grant of the option, or (b) one year from the exercise of the option, then the employee will be required to recognize as ordinary income the difference between the market value of the stock and the price they were able to buy the stock at through the exercise of their option.