The Compensation Puzzle: Options Versus Phantom Stock or Stock Appreciation Rights
Author: Gary Schafer
The challenges of retaining the best and brightest employees and attracting top talent are strategic concerns for many businesses. Employers may consider stock options or other variable compensation awards as parts of an effective compensation package for key team members. The specific structure of the plan you adopt can have a big effect on the accounting treatment, cash flow impacts and tax implications. Consider a few alternatives commonly considered by private companies: stock options versus phantom stock or stock appreciation rights.
Stock options give the recipient a temporary right to buy a number of shares at an exercise price defined at the grant date. The options vest, or become exercisable, over a period of time or once the conditions specified in the grant agreement are met. Some companies set time-based vesting schedules but allow options to vest sooner if performance goals are met. Once vested, the individual can exercise the option at any time until the option expires or is forfeited, which often occurs automatically after an employee is terminated.
Companies must use an option-pricing model to calculate the fair value of options on the date they are granted and show this as an expense on their income statement over the vesting period, typically with an offsetting increase to additional paid-in capital. The recognized expense should be adjusted based on vesting experience, so shares forfeited or cancelled before they vest do not count as a charge to compensation. If the option plan permits the employee to receive a cash payment instead of stock or requires the company to repurchase shares at the employee’s option, the company must record a corresponding liability on its balance sheet instead of crediting equity.
Options are either incentive stock options (ISOs) or nonqualified stock options (NSOs). While generally accepted accounting principles (GAAP) rules are similar for either type of option, the tax results differ.
When an employee exercises an NSO, the difference between the price paid for the shares and fair value of the stock as of that date is taxable to the employee as ordinary income, even if the shares are not yet sold. A corresponding amount is deductible by the company. Any gain or loss when the employee sells the stock is taxed as a capital gain or loss. Note: If the exercise price of the NSO is less than fair market value on the date the option is granted, it is subject to the deferred compensation rules under Section 409A of the Internal Revenue Code; it may be taxed at vesting and the option recipient subject to penalties.
By contrast, an ISO can offer tax advantages to employees; they can defer taxation on the option from the date of exercise until the date of sale of the underlying shares and apply capital gain tax rates—rather than the higher ordinary income tax rates—to the proceeds. The employer may get a tax deduction corresponding to the proceeds received by the employee when the stock is sold, but may get no tax deduction if the sale meets certain criteria. IRS deferred compensation rules don’t apply to ISOs. Certain specific conditions must be met to qualify for ISO treatment.
Phantom Stock & Stock Appreciation Rights
Phantom or virtual stock and stock appreciation rights (SARs) are similar in many respects. Both essentially are bonus plans that grant the right to receive an award based on the value of the company’s stock. SARs typically provide the employee with a cash or stock payment based on the increase in the value of a stated number of shares over a specific period of time. Phantom stock provides a cash bonus based on the value of a stated number of shares, to be paid out at the end of a specified period of time. SARs may not have a specific settlement date; as with options, the employees may have flexibility in when to choose to exercise the SAR. Phantom stock may offer dividend equivalent payments; SARs would not. The value used for determining compensation to be paid may be determined by an arbitrary formula based upon the company’s performance or derived from a third-party valuation of employer stock. When the payout is made, the value of the award is taxed as ordinary income to the employee and is deductible to the employer. Some phantom plans require the employee to meet certain objectives, such as sales, profits or other targets; these plans often refer to their phantom stock as “performance units.” If a phantom plan is broadly available to many groups of employees and designed to pay out upon termination, it is possible the plan could be subject to federal retirement plan rules, so this should be considered when structuring such programs.
Phantom stock and cash-settled SARs use liability accounting, meaning the associated accounting costs are not settled until they pay out or expire. For phantom stock compensation, expense is calculated by each period based upon the underlying value and trued up through the final settlement date. The compensation expense of SARs is estimated each period using an option-pricing model and trued up when the SAR is settled.
Puzzling It Out
Employees who exercise stock options at some point will want to sell the shares, at least in sufficient amounts to pay their taxes. Is there a market for the stock? On one hand, allowing employees to sell shares to outside investors avoids the need for the employer to come up with the cash for that portion of their compensation. On the other hand, to maintain control of who may own stock in the company, the employer may want a first right of refusal to purchase the shares or to simply require employees to sell the stock back to the company. Doing this may require cash payments on a schedule that are difficult to forecast in advance.
Because phantom plans and SARs are essentially cash bonuses, they avoid many of the potential problems associated with proliferating minority shareholders and can be simpler to administer and account for. However, the entire burden of funding the compensation expense under these programs remains with the employer. Careful planning and design can help mitigate some potential problems—for example, by providing the option to defer cash payments to periods when cash flow is available.
When considering which plan type may fit best, decision criteria may include the following:
- Cash flow – Can the company afford to pay cash bonuses when they would be due under a phantom stock or SAR program? Can it afford to repurchase shares of stock from employees? Care should be taken to structure cash requirements to fit company needs.
- Dilution of ownership – If the company is family-owned or closely held, what problems could arise from having an increased number of individuals holding small numbers of shares? These difficulties can include increased complexity of communication, more time spent on investor relations and potential complications in decision-making about the future of the business.
- Administrative complexity and costs – Application of option-pricing models for stock options can be complex and could require consultation with outside experts. If a plan is designed to require annual or periodic valuations of the company’s stock, this could be an additional cost if such valuations are not obtained for other purposes.
Contact your BKD advisor to help you put together the puzzle and structure an incentive compensation plan to effectively engage and retain your key employees.