Employee Incentive Plans

A couple of folks have asked for more information about stock plans for employees in light of my recent blog. In examining alternative plans for rewarding employees, you should first decide whether or not you choose to give either cash-based incentive plan or an equity based plan. This summary is for equity based plans.

Having said that...all credit to John H. Brown (www.exit-planner.net) for this information:

"After you have determined that an equity-based incentive plan would best meet the Exit Planning goals and objectives of your business owner, the next step is figuring out which plan would be most beneficial for the situation at hand. The following sections provide background information on three types of plans that you may choose to recommend.

1. Incentive Stock Option Plan (ISO)

ISOs are subject to numerous requirements, which include a written and approved plan by shareholders, as well as an option price that must be Fair Market Value and only can be offered to key employees. IRC Section 409(A) will likely impact this and the other plans described in this article. Be certain appropriate tax counsel is consulted before making planning decisions. The 409(A) final regulations are expected to be issued in late 2006.

With an ISO, a company makes a grant of a specific number of shares and the employee must exercise his or her option within 10 years. At the date of exercise, the employee pays the original Grant Price and incurs no tax consequences. When the employee subsequently sells that stock, the employee pays capital gains tax on the growth in value over the Grant Price, provided the holding period requirements are met. The holding period must be the later of: (1) two years from the grant or (2) one year from the date of exercise of the option by the Employee.

ISOs can be advantageous to companies and employees because they allow companies to attract and keep key talent in anticipation of a sale to a third party, without using cash flow. ISOs also are a good deal for employees because they do not incur costs with capital gains as the tax treatment. The biggest disadvantage of ISOs, from an Exit Planning perspective, is that they do nothing to handcuff an employee during the grant period. There also are no tax benefits to the company. As a result, ISOs are seldom used in Exit Planning.

2. Non-Qualified Stock Option Plan

Non-Qualified Stock Option Plans are less regulated than ISOs. The grant of an option to acquire a specific number of shares is usually limited to a specific time period and to a pre-determined price. Unlike ISOs, the difference between the Fair Market Value of stock and the exercise price is taxed as ordinary income at the time of the exercise. Therefore, the company receives a corresponding deduction. Again, if the employee leaves, stock is usually redeemed by the corporation. Similar to ISOs, a Non-Qualified Stock Option Plan rewards key players with ownership without draining company cash, and employees do not incur tax consequences at the time of the grant because closely held stock options do not have a readily ascertainable fair market value.

Similar to ISOs, a Non-Qualified Stock Option Plan rewards key players with ownership without draining company cash, and employees should not incur tax consequences at the time of the grant. On the flip side, this plan also does not handcuff employees during the grant period and employees experience the disadvantage of the ordinary income recognition at date of exercise on the difference between the exercise price and the Fair Market Value of the stock. Again, as with ISOs, Non-Qualified Stock Options are infrequently used in Exit Planning.

3. The Stock Bonus Plan

Like any other bonus, a Stock Bonus Plan can be based on a performance standard. (For instance, if a business makes $M or does "X," employee gets a predetermined amount of ownership.) Or, owners can simply deem whatever bonus amounts they feel are appropriate. The stock can be unrestricted or subject to substantial risk of forfeiture.

Stock Bonuses are compensation and taxed accordingly. When used as an employee incentive, the bonus stock is typically subject to a substantial risk of forfeiture. In that case, there isn't an income tax consequence to the employee or tax deduction allowed to the business, until, or as, the forfeitures lapse. As forfeitures lapse, ordinary income equal to the value of the unrestricted portion of the ownership interest is recognized by the employee and the company receives a corresponding deduction. Usually, the employee makes an "83(B) election" to recognize the income tax consequence at the time of the bonus or when the non-qualified stock option is exercised, even though the stock may be subject to full risk of forfeiture.

From an Exit Planning perspective, forfeiture provisions should be designed to support the owner's exit timeframe objectives. For example, if an owner plans on leaving the business in five years, advisors should design a forfeiture period that covers at least five years (and possibly longer) unless you create other incentives (such as having the employee buy the rest of the company). In essence, this provision is the basis for handcuffing employees and encouraging them to perform well during the business transfer period. Also, the company receives a tax deduction to the extent the employee recognizes income when making the 83(b) election. For these reasons, Stock Bonus Plans are frequently used in Exit Planning when the owner’s objective is to transfer at least some ownership to one or more employees

Overall, equity-based incentive plans are good planning tools to motivate, handcuff and reward employees as part of an owner’s Exit Plan. Before making this recommendation, however, you should review the advantages and disadvantages of cash-based incentive plans."

Year End Deadlines for Deferred Compensation

A friendly reminder.....the IRS has established a deadline of December 31, 2005 for amending nonqualified deferred compensation plans and agreements to comply with the Internal Revenue Code.

Now the deadline has been extended to December 31, 2006 .... but I would still recommend getting with your attorney and CPA and planning in the first quarter of 2006.

Health Savings Accounts

The IRS is continuing to provide guidelines for HSA.... a legal publication distributed to attorneys believes "HSAs will account for more than 10 percent of insured individuals by 2010." While tax free to the employee with a tax deduction to the employer, the non-discrimination rules applicable to many employee benefit plans do not apply to HSAs. There are some restrictions to covered parties, so please get with your professionals for specifics, but know this...with the "graying" of America, such plans could dramatically help to supplement an individual's source of monies for health related issues....in ways that employers, employees and the IRS support...when was the last time this happened in the last decade?

Top 10 Questions You Should Ask your Pension Consultant

Given the new mandates from your friends at the Department of Labor and the Securities and Exchange Commission concerning the "prudent expert" standard, it is now incumbent upon all companies, trustees of plans, money managers and retirement plan consultants to be sure to make full disclosure of all conflicts. How...............................

Refer to www.dol.gov/ebsa/newsroom/fso5310.

Failure to Remit Employee Health Premiums

A recent case involving a relatively common situation - officers of a company experiencing financial difficulties mandated officers choosing between several of the competing demands for money, was laid at their table...and they chose incorrectly. Employers can be liable for failing to remit employee contributions to the third party administrator of the company's self-funded health plan....and the officers can be PERSONALLY liable.(Phelps vs. C.T. Enterprises, Inc.). Lesson: Never divert employee monies......

Medicare Part D

In January 2006, Medicare Part D goes into affect, requiring new notice to retirees who are covered under a drug prescription plan. A plan sponsor may obtain a tax-free subsidy for continuing prescription drug coverage in an amount up to 28% of the plan's drug cost per retiree. See your attorney for details.....very complex, even for us construction attorneys, but a good deal for you!

Phantom Stock Option Agreements

With the problems created by the Enron and Worldcom scandals and the resulting regulations promulgated by the federal government, most businesses have become gun shy to incentive programs. Phantom Stock Options, what some would considered disguised bonus plans have been attacked in this regard unfairly, as these devises were widely used in many of the high tech start ups of the '90's. Richard E. Jackim shares his thoughts on the subject...I thought I frankly I agree with:

Don't Be Scared of Phantom Stock

By Richard E. Jackim

Motivating and keeping key employees is a essential part of maximizing the value of any business.  Many business owners feel that giving key employees an ownership stake in a company is the best way to do this.  WE DISAGREE.  Consider the following.  Using phantom stock you can "have your cake and eat it too".

Phantom stock or phantom equity is a concept that many business owners are not familiar with. Phantom stock can be a very powerful and cost effective way to motivate key employees so that they work to increase the value of the owner's company using the "motivation of ownership". 

Instead of giving employees regular stock, a phantom equity program gives the employee something that looks and feels like stock but is not stock.  Instead, the employee is awarded “Phantom Shares,” which have many of the attractive features of shares of stock without some of the drawbacks.  Many business owners like phantom shares because they allow employees to participate in the financial rewards of ownership without having a voting interest and without the complications associated with having additional shareholders involved in the company.

In addition, from the business owner's perspective, phantom shares are often preferred over traditional shares because they can be subject to vesting requirements, they can be forfeited upon an employee's termination or departure, and they can be repurchased using payment schedules.  Unlike traditional shares that need to be repurchased under the terms of a buy/sell agreement when an employee departs or is terminated, phantom shares can disappear based on certain triggering events.

Phantom shares can also be valued using any formula that an owner and his advisors deem appropriate. For example, the phantom shares in one client's company are valued based on the value of the company over and above the value of the business when the phantom equity program was started.  That way the employees only participate in the additional value that they help to deliver and do not participate in the value that already existed.

Phantom equity programs also have several significant tax advantages that are attractive to both business owners and the key employees.

First, when a key employee receives shares under the company’s phantom equity program, the IRS does not recognize that receipt as taxable income to the employee until he or she actually receives the money.  This usually occurs when the company is sold or when the employee retires and is cashed out (assuming the employee's phantom shares are vested).  This is very attractive considering that regular shares are taxes as ordinary income and the employee basically has to pay the associated tax even though he or she didn't receive any cash.

When the phantom shares are redeemed, the key employee would receive ordinary income, rather than capital gains, tax treatment on any amounts received for his or her phantom shares.  However, keep in mind that the employee was not taxed while employed by the company, meaning that employee can effectively defer payment of taxes on this benefit until a liquidity event or retirement occurs.  The time value of deferring these taxes can be significant.

Second, when the company pays a key employee to redeem phantom shares, the company can treat it as an expense rather than a repurchase of shares and the company receives a tax deduction.  If the company were redeeming traditional shares the event would have no tax benefits to the corporation.  In that situation, the company must use as much as $1.40 or $1.60 of its pre-tax cash flow to repurchase the shares on an after-tax basis.  This makes repurchasing real shares very expensive relatively speaking.

We encourage you to discussion phantom equity programs with your attorney or CPA to see if one would be an effective way to motivate your employees to increase the value of your company.  It is important that you consult with professional advisors to discuss your specific situation.