Finding incentives to engage key employees is a challenge. Some employers may have considered stock options or other alternative variable compensation as part of an effective compensation package for key team members. The adopted plan’s specific structure can significantly affect the accounting treatment, cash flow effects and tax implications. Considerations important to this decision may have changed due to different company dynamics, accounting rule changes or the employment market. Picking the right compensation plan can be critical to achieving desired results.
Stock options give the recipient a temporary right to buy a number of shares at an exercise price defined at grant date. The options become exercisable through a period of time or once the grant agreement’s conditions 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 it expires or is forfeited, which often automatically occurs with employee termination.
Companies must use an option-pricing model to calculate the fair value of options on the date they’re granted and show this as an expense on their income statement through the service period, typically with an offsetting increase to additional paid-in capital if the award isn’t required to be accounted for as a liability.
There are two options: incentive stock options (ISO) or nonqualified stock options (NSO). While generally accepted accounting principles are similar for either option, the tax results differ.
When an employee exercises an NSO, the difference between the price paid for the shares and the stock’s fair value as of that date is taxable to the employee as ordinary income, even if the shares aren’t 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. If the NSO’s exercise price is less than fair market value on the date the option’s granted, it’s subject to the deferred compensation rules within Internal Revenue Code Section 409A, Nonqualified Deferred Compensation Plans; it may be taxed at vesting and the option recipient is 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 the underlying shares are sold 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 the employee received when the stock is sold. IRS deferred compensation rules don’t apply to ISOs. Certain specific conditions must be met to qualify for ISO treatment.
One advantage of many stock option plans is that they qualify to be accounted for as equity in the employer’s financial statements. However, if the plan requires or allows for cash settlement options, the employer may be required to account for the outstanding options as a liability on its balance sheet.
Phantom Stock & Stock Appreciation Rights
Phantom or virtual stock and stock appreciation rights (SAR) are similar. These essentially are bonus plans that grant the right to receive an award based on the company’s stock value. SARs typically provide the employee a cash or stock payment based on the increase in the value of a stated number of shares through a specific period. 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. SARs may not have a specific settlement date; the employees may have flexibility in choosing when to exercise the SAR. Phantom stock may offer dividend equivalent payments—SARs won't. The value used to determine compensation may be found 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 award’s value is taxed as ordinary income to the employee and deductible to the employer. Some phantom plans require the employee to meet certain objectives, e.g., 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 employee groups and designed to pay out upon termination, the plan could be subject to federal retirement plan rules, which should be considered when structuring such programs.
Phantom stock and cash-settled SARs use liability accounting, meaning the associated accounting costs aren’t settled until they pay out or expire. For phantom stock compensation, expense is calculated by period based on 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, unless the company has elected to account for equity-based plans using the intrinsic value method.
New Option – Profits Interests
Through the years, profits interest plans have significantly increased in popularity, especially in nonpublic limited liability companies. With a profits interest plan, participants are granted an equity interest in future company profits. The structure of these plans is flexible with compensation calculation and vesting determination. Determining the fair value of profits interest awards at issuance can be challenging. While many of these plans are structured to only pay out when the interests are redeemed upon liquidation and accounted for as equity, some plans provide for redemption features that can result in the employer recording a liability on its balance sheet. In those cases, the option to elect intrinsic value accounting for such awards may be popular among nonpublic employers.
Employees who exercise stock options eventually will want to sell the shares in sufficient amounts to pay their taxes. Allowing employees to sell shares to outside investors avoids the need for the employer to produce the cash for that portion of their compensation. However, if the employer wants to control who owns company stock, it should require the first right of refusal to purchase the shares or that employees sell the stock back to the company. Doing this may require cash payments on a schedule that are difficult to forecast.
As phantom plans and SARs are essentially cash bonuses, they avoid many potential problems associated with proliferating minority shareholders and can be simpler to account for and administer. However, the entire burden of funding the compensation expense with these programs remains with the employer. Careful planning and design can help mitigate some potential problems, e.g., providing the option to defer cash payments to periods when cash flow is available.
When considering which plan type fits best, decision criteria could include:
Cash flow – Can the company afford to pay cash bonuses when due in a phantom stock or SAR program? Can it afford to repurchase stock shares from employees? Care should be taken to structure cash requirements to fit company needs. If the plan can be structured to defer paying employees until an anticipated liquidity event for the company, cash flow becomes less of a concern.
Dilution of ownership – If the company is family-owned or closely held, what problems could arise from more individuals holding small numbers of shares? These could include increased complexity of communication, more time spent on investor relations and potential complications in making business decisions.
Administrative complexity costs – Applying option-pricing models for stock options can be complex and require consultation with outside experts. If a plan is designed to need annual or periodic valuations of the company’s stock, this could be an additional cost if such valuations aren’t obtained for other purposes. Of course, with the new simplifications described above, in some situations these complexities may be reduced.
Contact your BKD advisor to help you structure an incentive compensation plan to effectively engage and retain your key employees.