Cash based Long Term Incentive Pay
Long Term Cash Incentive Pay is a performance driven award that pays compensation based on a three to five year performance period and calculated as a multiple of base salary. Performance can be measured against an industry peer group of companies and the projected long term growth of the company, just to name a few. Awards are based on a multiple of base salary.
The award of stock options represents the most commonly used form of long term performance incentives. The grant awards are designed to incentivize the executive to perform because he or she has a long term stake in the future of the company, through eventual stock ownership. A majority of public companies issue fixed priced stock options (fair market value determined on the date of the grant). Start up companies and other privately held companies often engage in the issuance of “in the money” stock options, options that have a strike price that is below the fair market value. Among these companies, the fair market value is not readily ascertainable and the compensation committee seeks to promote increased incentives among initiating employees/incorporators. The present and immediate future value of these business entities is a direct function of employee initiatives and performance.
The taxation of stock options is routinely debated, and revolves around the issue of when the “property” transfer has taken place. Property transfer for taxation purposes can occur at the date of grant or on the date of exercise. The sole determining factor is whether the option has a readily ascertainable fair market value on the date of grant. Section 83 of the IRS Code has provided a method of making this determination: 1) the option is transferable, 2) the option is immediately exercisable on the grant date, 3) the option or the underlying stock has no restrictions that adversely affect on the valuation of the option, and 4) the option privilege has a readily ascertainable fair market valuation. The taxation is based on the “spread” between the fair market valuation of the stock on the exercise date and the controlling exercise price. Treasury Reg. § 1.83-7(b)(2)(3).
1. Non-Qualified Stock Options
Non-Qualified Stock Options (or also known as Non-Statutory Stock Options “NSO’s”) are governed by I.R.C. § 83, and provide a performance compensation method to acquire shares of the corporation’s stock, a non-transferable equity interest either at a discounted price (“in-the-money”) or at the market value (“on-the-money”). Generally, NSO’s provides the executive the right to purchase the company’s stock at a fixed price (“exercise price”) during a fixed period of time. Vesting can occur on the date of grant (rare) or ratably over a period of months or years, (10 years is typical) pursuant to the company’s stock option plan documents. Upon termination, generally all vested options must be exercise within 90 days, after which they become forfeited.
NSO’s are generally taxed at the ordinary income rate on the exercise date, and derived from the difference between the fair market price and the strike price. Any subsequent change in the fair market value of the stock, will be treated as a capital gain or loss when the executive sells the acquire stock.
2. Incentive Stock Options (ISO)
Incentive Stock Options (“ISO’s”) are governed by I.R.C. § 422. ISO’s are considered executive friendly. If all statutory requirements are met, any income received upon exercise will be treated as a capital gain. However, any excess maybe subject to the Alternative Minimum Tax. Employers are not entitled to any deduction. Similar to NSO’s, the executive receives a right to acquire equity in the corporation. Vesting may occur ratably and all exercises must take place within 10 years. Under current ISO rules, no more than $100,000 of stock options may become exercisable in any given year. Upon termination, generally all vested options must be exercised within 90 days, after which they become forfeited.
Restricted Stock awards are outright grants of stock, for cash or nominal cost, to the executive with specific restrictions on sale, transfer and pledging. Restricted stock is intended to induce performance, because the employee is a shareholder of the corporation. Upon vesting, the receipt of the restricted stock is treated as compensation income, i.e. the difference between the market value at the date the termination of restriction occurs and any subsequent change in value of the shares treated as capital gain or loss. During the restriction period, the holder is entitled to receive dividends and can vote the shares vested. Similar to stock options, upon termination all unvested restricted stock is forfeited.
For tax purposes, generally restricted stock granted to induce performance are not subject to federal income tax until the restriction lapses or the stock becomes transferable.
STOCK APPRECIATION RIGHTS (SARS)
SARS are rarely used and differ slightly from Phantom Stock and Stock Options. SARS entitle the holder to the spread in fair market value between the grant date and the exercise date. Unlike options, SARS do not require a cash tender on the exercise date and do not pay a dividend like a phantom stock. SARS may be issued on a “stand alone” basis or along with an option. Upon exercise of the SAR, the holder realizes the stock and/or cash as compensation income on a capital gain or loss basis. Due to changes in SEC Rule 16b-3, the need for SARS is greatly reduced.
Limited SARS are negotiated for purposes of change in control situations, but are limited to the triggering provisions in the agreement.
PHANTOM STOCK PLANS (Restrictive Stock Units)
Restrictive Stock Units are rarely used by most companies. The holder of the unit is entitled to the spread between the price of the underlying stock on the grant date and the fair market value or formula value of the stock on the settlement date, which is not the vesting date. These units are settled upon retirement, termination from employment or some other fixed date selected by the executive. At settlement, the award may be payable in a lump sum or in installments over a period of years. The holder of the units may be entitled to dividends on the underlying stock.
PERFORMANCE UNIT PLAN AWARDS (PUPA)
Performance Unit Plan Awards are contingent upon the attainment of corporate performance goals, usually measured over a period from three to five years. PUPA’s are contractual arrangements that provide for predetermined performance goals or targets, and the designated dollar amount awards are based on the percentage of attainment of indicated goals. Awards are paid in cash or company stock, with no investment by the executive. A failure to achieve the minimal percentage forfeits the PUPA’s under the plan. Performance goals or targets are normally based on increases in earnings per share of common stock averaged over a period of years pursuant to the plan. Other goals also used are return on equity, increased market share, competitive group performance comparisons, and internal division, subsidiary and unit level performance.
PERFORMANCE SHARE PLANS
Performance share plans function similarly to Performance Unit Plan Awards. However, the executive is granted contingent shares at the start of the three to five year performance period. No investment is made by the executive to acquire the contingent shares.
Have Our Employment Lawyers Review Your Incentive Pay
Contact the employment attorneys at Carey & Associates, P.C. today at (203) 255-4150 to review your long term incentive pay agreement. We will make sure your incentive agreement is competitive with other professionals in your field and reflects the value you bring to your company. Our employment lawyers work to help employees located in Connecticut, Manhattan and New York.