EMPLOYEE INCENTIVES
by Corporate Law Enterprise Expert Colleen Pleasant Kline, Principal Miles & Stockbridge P.C.
Many women business owners wonder about what is the right way to reward their employees? At a certain point, when someone contributes to the increasing value of the business the usual inclination is to want to consider sharing a piece of the pie or profits in a meaningful way as a means to keep the staff member engaged, or involved. There’s many ways to go about this, but it can be confusing and not all rewards are equal. We asked Corporate Law Enterprise Expert Colleen Pleasant-Kline, a Principal with Miles & Stockbridge to shed some light on the issue and this is what she shares with our audience
I often hear the question, how do I reward my employees? As the economy continues to restrain cash reserves and challenges cash flow management, more clients are looking to provide non-monetary incentive programs to attract, reward, or retain key employees.
Frequently this has employers looking at stock (and other equity) incentive programs. There are many different forms of stock or equity incentive programs with their own advantages and disadvantages and different tax treatment. It is extremely important that before you introduce any type of incentive program that you speak with an attorney and other tax professionals to make sure that it is properly structured for your company and your employees, otherwise you may find that instead of rewarding your employees positively, you gave them a large tax bill.
PHANTOM STOCK PLAN
Phantom stock or phantom equity plans are a popular choice among employers. These plans allow employees who are eligible to participate to become entitled to a certain percentage of the company’s equity, and some may provide for profit distributions from operations annually. Eligibility is usually dependent upon the occurrence of certain key events, such as the sale or merger of the company. These plans can contain vesting and forfeiture provisions tied to the employee’s continued employment and set forth other restrictions. Phantom equity plans do not grant an employee actual ownership in the company, but rather the right to receive a portion of the value of the company, such as the proceeds from a sale or upon distribution of profits. Any payment under the plan is taxed at ordinary (compensation) income rates to the employees and is deductible by the employer as a compensation expense. Phantom equity awards must comply with deferred compensation rules and must be very carefully structured to avoid unintentionally creating an adverse tax issue for your employee.
STOCK APPRECIATION RIGHTS
Stock Appreciation Rights (“SARs”) grant an employee the right to receive cash or stock equal to the appreciation in value of a share of the company’s stock from the time of grant or exercise. SARs are a contractual right and do not grant ownership in the company until the stock is issued and are also customarily subject to vesting and forfeiture restrictions. The SAR benefit is taxable to the employee as compensation (ordinary) income and deductible by the employer when exercised. Unless the exercise price at time of grant is equal to the fair market value of the shares at that time, the SAR award will be subject to the 409A deferred compensation rules and must be very carefully structured to avoid unintentionally creating an adverse tax issue for your employee.
STOCK OPTIONS
In contrast, stock option plans are created with the intent of granting employees ownership in the company. Essentially stock options grant the employee the right to acquire stock at a later point in time at an agreed upon price after all vesting and forfeiture provisions have been satisfied. If an employee leaves, any vested options which have been exercised may result in the payment of cash for the return of the stock. Any unvested options are generally forfeited with no cash value. Stock options must be carefully drafted to avoid adverse tax consequences and penalties to the employer and employee. Like SAR’s, if the exercise price for the options is less than the fair market value of the underlying shares at the time of the grant, the options must conform with 409A rules of the Internal Revenue Code related to deferred compensation. If the option is awarded under a tax-qualified program, all options have been exercised, and the underlying stock held for the required holding periods, it may be possible for an employee to obtain capital gains treatment on the full option benefit at the time of any subsequent sale of the stock. However, employees frequently do not exercise their options until a sale event (as it often requires payment to do so), and therefore many do not enjoy the benefits of capital gains tax treatment.
RESTRICTED STOCK
Like stock option plans, restricted stock gives employees ownership in the company. In contrast to a stock option grant, restricted stock is an outright grant of equity in the employer at the time of the grant. Similar to the stock options, it may be subject to vesting and forfeiture restrictions, is frequently for non-voting stock, and contains restrictions on the transferability of the stock in the future. Like a stock option, any vested shares may trigger a cash-out of stock held by the employees. Unlike other types of equity awards, restricted stock awards are generally not governed by the 409A deferred compensation rules. However, if your company is taxed under subchapter S of the Internal Revenue Code, the offer of restricted stock becomes more complex and likely too expensive for the company to adhere to the various statutory restrictions and differences in allocations of profits and losses between state and federal and regulations.
DISCLAIMER: Opinions and conclusions in this post are solely those of the author unless otherwise indicated. This article is for general information purposes and is not intended to be and should not be taken as legal advice on any particular matter. It is not intended to and does not create any attorney-client relationship. Since legal advice must vary with individual circumstances, do not act or refrain from acting on the basis of this article without consulting professional legal counsel. If you would like additional information on the subject matter of this article, please feel free to contact the author. IRS CIRCULAR 230 NOTICE: Any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding federal tax penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.