The Competitive Edge:
Creating Attractive Incentive Compensation
Plans for Privately Held Entities
Keith H. Berk, Jeffrey A. Hechtman, and Kenneth A. Goldsteini
A discussion of alternative incentive compensation plans and the
application of executive compensation plans in closely held businesses.
INTRODUCTION
As companies vie for executives with track records of proven success, executive compensation has
taken on increased importance for businesses in today’s highly competitive job market. Executive
compensation plans can make the difference in attracting and retaining the key personnel required to
manage successful businesses.
For years, corporations have expended great time and effort to develop compensation
packages for key personnel to balance management’s focus between short term and long term
concerns and create a bond of common interest between shareholders and senior management. These
compensation structures not only provide a means of attracting and retaining senior management but
can also serve as an effective motivational device for focusing the executive’s interests to achieve
specific corporate performance objectives. Incentive plans can also preserve working capital by
splitting compensation into short term and long term components.
AVAILABLE ALTERNATIVES
Executive incentive plans can generally be separated into two classes: equity-based plans in which
the executive has an actual or potential equity stake in the company and equity-like plans that give
rise to cash payments but do not provide the executive actual equity ownership. Equity-based
incentives include stock option plans, stock bonus plans, and stock purchase plans. Cash-based
equity-like programs are comprised of stock appreciation right plans, phantom stock plans, and
performance unit plans.
The principal distinctions between equity-based plans and cash-based equity-like plans are
the benefits and burdens that accompany actual ownership in an entity. In equity-based plans, the
executive, upon becoming a shareholder, is entitled to certain benefits including the rights to vote,
receive notice of meetings, inspect the books and records, and hold directors, officers, and majority
shareholders accountable as fiduciaries. On the other hand, equity-like plans are contractual
obligations which, while subject to the implied covenants of good faith and fair dealing, do not
subject the enterprise or the other shareholders to obligations owed to minority shareholders.
The company’s choice will be based on several factors such as ownership structure, business
strategy, and the role of outside personnel in growing and managing the business. In general, closely
held businesses prefer not to give actual equity ownership to executives unless the benefits are
provided pursuant to a broad based plan for many executives, true equity will better motivate the
Doc: 131219/1/HM&B
1248211/1/13541.000
executives than economic rewards, or the tax benefits of equity-based plans are superior to the tax
consequences of equity-like plans.
The principal issues for the executive in connection with incentive plans will concern income
tax treatment of the different plans and the psychological perception of true ownership versus a
participation right in the company’s economic well being.
DESCRIPTION, COMMON FEATURES, AND TAX CONSIDERATIONS OF EQUITYBASED PLANS
Stock Options
A stock option is not stock; it is the grant of a right to purchase stock at a specific price (the "exercise
price") on or after a specified future date subject to specific terms. Options can be granted based
upon a number of criteria, including position, tenure, past contributions, or the expectation of future
performance. There are two basic types of stock options: Incentive Stock Options (ISOs) and NonQualified Stock Options (NSOs). The primary differences between NSOs and ISOs lie in their
relative flexibility and tax consequences.
Incentive Stock Options
ISOs are options granted to an employee to purchase stock which meet the following statutory
requirements:ii
·
·
·
·
·
·
·
·
Doc: 131219/1/HM&B
1248211/1/13541.000
Following exercise of the options the employee may not dispose of stock that is
purchased within two years from the date that the options were granted or within one
year after the options are exercised;
The executive must be an employee of either the company, its parent, or a subsidiary
at all times during the period from the date the options are granted until three months
before the date of exercise;
The options must be granted pursuant to a plan which states the aggregate number of
shares that may be issued to the employees (or class of employees) eligible to receive
the options and that is approved by the shareholders of the company within twelve
months of the date the plan is adopted;
The options must be granted within ten years from the date the plan is adopted or the
date the plan is approved by the shareholders, whichever is earlier;
The options must be exercisable within ten years from the date of grant;
The option price may not be less than the fair market value of the stock at the time
the option is granted;iii
The options must be nontransferable other than at death and must be exercisable only
by the employee during the employee’s lifetime;
At the time the options are granted, the employee must not own more than 10 percent
of the total combined voting power of all classes of stock of the company, its parent,
or subsidiaries, either directly or by reason of attribution of stock;iv and
·
The aggregate fair market value of stock that can be purchased by the employee
pursuant to options exercisable for the first time during any calendar year under all
plans of the company, its parent, and subsidiaries, may not exceed $100,000.v Fair
market value for this purpose is determined at the time the options are granted, based
on the order the options were granted.
Tax treatment of ISOs. An executive does not recognize income when an ISO is exercised.vi
Upon the eventual sale of the underlying stock, the executive will recognize a capital gain based on
the difference between the sales price and the exercise price. The company receives no deduction in
connection with the granting or exercise of ISOs.
Advantages and disadvantages of ISOs. Gain on the sale of stock purchased pursuant to an
ISO is taxed at capital gains rates. Given the new capital gains rates, which are as low as 20 percent
and the ordinary income tax rates, which are as high as 39.6 percent, the executive not only receives
a benefit from the company but also pays the historically lower rate applicable to capital gains.
Although the company receives no corresponding deduction, it benefits by compensating the
executive without a cash outlay and without paying the withholding taxes that accompany payment
of regulatory compensation. Moreover, the holding period requirements create an incentive for the
executive to remain with the company and to focus on long term growth and strategy.
The major disadvantages of ISO’s are the burdens of the strict ISO requirements. A company
may not grant ISOs that have an exercise price that is less than the current fair market value of the
stock; therefore, an ISO will not provide the executive any compensation unless the value of the
company increases. The company may find that executives do not consider ISOs to be
"compensation" because the options have no economic value when granted. As with all equity-based
plans, the employee may become a shareholder, diluting the investment of existing shareholders and
entitling the employee to hold majority shareholders, directors, and officers accountable as
fiduciaries.
ISO requirements have several features that the employee may also find troublesome. The
employee may pay for the stock only by certain statutorily prescribed methods.vii Also, holding
period requirements prevent the employee from disposing of the underlying stock within two years
from the date of grant or one year from the date of exercise of the ISO and can frustrate the
employee’s ability to take advantage of market upswings. Furthermore, since ISOs cannot be
transferred, the lack of transferability eliminates the employee’s ability to transfer the ISOs to
descendants to reduce the employee’s estate for estate tax purposes. Finally, the employee may owe
tax upon exercise to the extent he is subject to the AMT.
Non-Qualified Stock Options
NSOs are options that do not satisfy the statutory requirements of ISOs and because of their
flexibility and tax advantage, are more typically used in closely held businesses.
Exercise price. NSOs may have a fixed exercise price, a variable exercise price, or an
exercise price that has fixed and variable components. Because NSOs are not required to meet the
stringent fair market requirements applicable to ISOs, the company has the flexibility of setting the
exercise price above, below, or equal to the fair market value of the stock at the time of the grant. By
Doc: 131219/1/HM&B
1248211/1/13541.000
using NSOs that are already "in the money," the company can use NSOS to provide an executive
with a bonus for performance achievements while at the same time preserving cash and providing
incentives for future achievements.
Variable exercise prices can be based on performance criteria such as sales, profits, earnings
per share, or cost reductions. As the level of performance improves based on the measuring
threshold, the variable exercise price can be adjusted to make the options more valuable, thereby
aligning the executive’s incentives with specific goals of the company. However, the company
should be careful in selecting measuring criteria that are meaningful to the executive’s performance
and do not create a perception that the executive’s compensation is independent of performance.
Holding periods and vesting. Given that the features of the NSOs are not mandated by
statute, no minimum period is prescribed for exercising options or holding stock purchased under an
NSO plan. Consequently, a company has flexibility to establish restrictions that balance the
executive’s desire for current compensation with its long term goals. Typically, NSOs provide for
delayed exercise periods or establish minimum holding periods in order to create an incentive for the
employees to remain with the company and take a long term view of the company’s success.
NSOs are frequently subject to vesting provisions that provide that the employee will not
have an indefeasible right to the options or the underlying stock until the expiration of certain periods
of time or the occurrence of specific events. The most common vesting methods involve vesting
over a fixed period or "cliff vesting," which provides that all vesting occurs at a certain point in time.
Of course, the two methods can be combined to tailor an option plan to the company’s and the
employee’s desires. The company’s choice of a vesting schedule should focus on a time period that
is sufficient to achieve the desired long term results from the executive.
Transferability. With recent changes in the Code making the transfer of NSOs possible, an
executive may be able to substantially reduce federal estate and gift tax liability by making lifetime
transfers of the NSOs. Typically, the most advantageous time to transfer NSOs is shortly after their
grant. The executive may transfer the NSOs directly to family members, a trust for the benefit of
family members, or, possibly, to a family limited partnership.
The value of a gift of NSOs will be equal to the fair market value of the NSOs on the date of
the gift. Typically, this value will be substantially less than the value of the stock when the NSOs are
exercised. Following the gift, any further appreciation in either the value of the options or the
underlying stock will not be subject to additional estate or gift tax. However, there is a risk that the
underlying stock price may never reach the exercise price. In such case, the Code does not permit
the employee to reclaim the lost exemption or recover any gift tax that was paid. The gift of the
NSOs should not create any income tax liability and does not affect the income tax consequences to
the executive upon exercise of the NSOs by the family member.
Tax treatment of NSOs. NSOs result in immediate taxation if at the time of grant the options
have a "readily ascertainable fair market value."8 If the NSOs have a readily ascertainable fair market
value, the employee has ordinary income equal to the difference between the fair market value of the
NSOS less the exercise price, and the company receives a corresponding deduction. While the
difference between fair market value and the exercise price is taxed at ordinary income rates, any
future appreciation in the value of the NSOs or the underlying stock is taxed at the capital gains
rates.9 In closely held businesses, the granting of NSOs seldom results in immediate recognition of
taxable income because the options will not have a readily ascertainable fair market value.10
Doc: 131219/1/HM&B
1248211/1/13541.000
If the NSOs have no readily ascertainable fair market value on the date of grant, the executive
will recognize income equal to the difference between the fair market value of the underlying stock
and the exercise price of the options on the date the NSOs are exercised and the underlying stock is
not subject to a substantial risk of forfeiture.11 A substantial risk of forfeiture exists if the options are
subject to or dependent on a future event or condition that would result in termination of the NSOs
by payment of less than fair market value. However, restrictions that never lapse, such as a
requirement that the underlying stock be sold to the company at a predetermined price or a formula
price on the executive’s termination, are ignored for determining the time for income recognition.
The company is entitled to a business expense deduction when the executive is required to
declare ordinary income, which is limited to an amount equal to the ordinary income declared by the
executive.12 The deduction will only be allowed to the extent that the executive’s total compensation
is "reasonable".13 Moreover, the company is also subject to withholding requirements applicable to
employee compensation. When the executive eventually sells the stock, the excess of the sales price
over the sum of the exercise price and ordinary income previously recognized is taxed at the capital
gains rate to the employee. No further deduction is available to the company on sale of the stock.
Advantages and disadvantages of NSOs. Since there are few specific legal requirements for
NSOs, their range of features is quite broad. NSOs are advantageous because the company does not
directly pay for the benefit realized by the executive.14 This feature is particularly attractive to early
growth stage businesses for which compensation of talent must be balanced with the need for capital.
The tremendous wealth-building potential offered by NSOs is especially effective in attracting
executive talent that is willing to sacrifice short term compensation for a chance to participate in the
company’s upside. Moreover, NSOS provide a non-cash method of awarding bonuses for attaining
goals and motivation for continued performance. NSOS also allow companies to compensate
individuals who do not qualify as common law employees,15 such as directors and strategic third
parties. Finally, vesting and holding periods result in capital investment by executives in the
company, further linking shareholder and management goals. Overall, the flexibility in pricing,
holding periods, permissible participants, and times and methods of exercise make NSOs more
useful vehicles than ISOs for tailoring a plan to a company’s needs to attract, retain, and provide
incentives for employees.
Notwithstanding these benefits, NSOs impose costs that both the closely held business and its
owners must bear. The exercise of the NSOs provides the executive with all of the rights of a
minority shareholder and results in the dilution of the interests of the other shareholders. Moreover,
the benefit ultimately provided is not directly related to the executive’s performance, but to the
company’s performance as a whole. Consequently, the executive may become disenchanted upon
realization that his performance may not result in a commensurate benefit. The executive generally
recognizes ordinary income on the date of exercise and, if he only receives stock on the exercise of
the option, the executive may not have the funds to pay the resulting tax. This hardship may be
alleviated by combining NSOs with stock appreciation rights or a grossed up cash bonus that enables
the executive to pay the resulting taxes. Moreover, the company is required to withhold taxes from
the executive, but may not have a source of the executive’s funds from which to withhold.
Stock Bonus Plans
Doc: 131219/1/HM&B
1248211/1/13541.000
A stock bonus plan involves the outright grant of stock to the executive. The grant may be based on
factors that include the executive’s role and position in the company, the company’s performance,
the performance of the executive’s division, or the executive’s job performance. Generally, the
closely held business will subject the executive’s stock to a substantial risk of forfeiture that lapses
on vesting and to restrictions on transferability that never lapse.
Unvested shares of bonus stock are usually subject to forfeiture on the executive’s
termination of employment, death, permanent disability, retirement, or resignation.16 Similar to
stock options, the company may vest the stock in the executive by means of vesting over time, cliff
vesting, or any combination of the two. Vested stock will generally be subject to the same
restrictions as other stock of a closely held business such as a requirement that the stock be resold to
the company or the other shareholders at a predetermined price upon termination of employment,
death, permanent disability, retirement, or resignation.
Stock bonus plans are not subject to statutory requirements, and thus are extremely flexible.
To increase the effectiveness of the incentive as both a retention and motivational device, vesting can
be made contingent on specific performance targets, such as stock price, earnings per share, net
income, or unit profit contribution. The plan may also provide for negative consequences if targets
are not met.
Similar to NSOS, the executive realizes ordinary income and the company receives a
deduction on the grant of a stock bonus in an amount equal to the fair market value of the stock when
the stock is no longer subject to a substantial risk of forfeiture. In addition, the company is subject to
withholding requirements applicable to compensation.
If the stock is subject to a substantial risk of forfeiture, the executive does not have to declare
income until the substantial risk of forfeiture lapses. However, the executive may elect to include in
income for the taxable year the excess of the fair market value of the stock at the time of the transfer
less any amounts paid for the stock in order to allow subsequent appreciation to be taxed at the
capital gains rate rather than ordinary income rates.17 This election is typically made in
circumstances in which substantial appreciation is anticipated before the applicable restrictions lapse.
The election does not entail risk to the executive in the event the stock value declines or the stock is
forfeited because no subsequent deduction is allowed for diminished value.
Stock bonus plans may be useful in attracting key personnel. These plans enhance capital
accumulation, provide a cash-free method for recognizing past performance, and provide incentive
for future performance. Moreover, the dividend and voting rights that attach to the stock serve as
reminders of the executive’s economic interest in the company’s success. Stock bonuses subject to
vesting schedules also serve as golden handcuffs, encouraging long-term executive employment and
discouraging short-term job switching.
Stock bonuses also possess a downside. Because the executive does not pay for the stock, the
motivational impact is limited because the executive receives a benefit regardless of his, or the
company’s achievements. A stock bonus plan may also make the company less attractive to banks or
venture capitalists who do not care for ownership to be given away at no cost. Finally, other
shareholders that have invested in the company may resent that the company gave stock to the
executive.
Nonstatutory Stock Purchase Plans
Doc: 131219/1/HM&B
1248211/1/13541.000
A nonstatutory stock purchase plan18 is similar to a stock bonus plan with two exceptions: (1) The
company’s shares are sold, rather than given, to the executive at either full market value or at a
bargain purchase price, and (2) the plan cannot require the executive to forfeit purchased shares if he
does not meet certain requirements or leaves prior to vesting. However, the stock purchase plan may
compel resale upon the occurrence of certain events using a formula that results in a deeply
discounted sales price on termination, which could be payable over a term of years. In order to
alleviate the executive’s cash flow problems, the company may loan or bonus the executive all or
part of the purchase price of the stock or finance the purchase through installments deducted from his
salary. Again, the purchase price can be set below fair market value to provide a measure of current
compensation along with the long term incentive.
The difference between the fair market value of the stock and the purchase price is taxed as
ordinary income to the executive. The company receives no deduction for the purchased stock
unless income is recognized by the executive. Since established markets rarely exist for closely held
stock, fair market value is generally determined by appraisal, thereby permitting certain leeway in
establishing the fair market value of the company.
The principal advantage of a stock purchase plan is the affirmative investment of capital in
the company by the executive. The investment will motivate the executive and provide a strong
retention device as well as preserve the company’s cash for working capital. On the other hand, the
executive may be reluctant to pay for stock from his salary and, therefore, find the plan attractive.
CASH BASED EQUITY-LIKE PLANS
Cash based equity-like plans offer alternatives to equity-based plans that enable a company to mimic
the economic rewards of equity-based compensation without the burdens that accompany equity
transfers. The most common equity-like plans are stock appreciation rights, phantom stock, and
performance units. These compensation packages are often used as a supplement to an equity plan.
Because cash based equity-like plans are merely contractual arrangements and do not provide for
actual stock ownership, the executive does not have the rights of a minority shareholder and the
company is not subject to the obligations due to shareholders in equity-based plans.
Stock Appreciation Rights
SARs are a contractual obligation between the employer and the executive that provides for
compensation based on the value or increase in value of the measuring factor (typically, the value of
the company’s stock) at certain points in time or upon the occurrence of certain events.
Common Features of Stock Appreciation Rights
SARs entitle the executive to cash, stock,19 or both based on the appreciation in the designated
measuring factor. Although the value of SARs may be based upon any measurable factor such as
gross sales or net profit of the executive’s division, most SARs are valued based on the value of the
company’s stock. The company may pay the benefit on a fixed settlement date or upon the
occurrence of certain events such as the sale of the company or an initial public offering.
Doc: 131219/1/HM&B
1248211/1/13541.000
As with options, SARs may be subject to vesting periods that allow the company to tie the
bene fits to long term performance and employment. Finally, SARs are frequently tied to options in
order to alleviate the cash flow problems facing employees at the time options are exercised.
Taxation of Stock Appreciation Rights
A grant of SAR, by itself, is not considered property. Therefore, the grant is not taxed as a transfer
of property in connection with the performance of services. When the SAR leads to payments or the
issuance of stock, the executive recognizes the ordinary income equal to the cash plus the fair market
value of any property received, and the company is entitled to a corresponding deduction.20
The company is also subject to withholding requirements.
Advantages and Disadvantages of Stock Appreciation Rights
SARs are ideal for closely held corporations that do not want to relinquish equity in the company.
Due to their contractual nature, SARs have flexibility which allows the company to approximate the
compensation plans of competitors and target incentives to areas that require focus. Furthermore, the
executive does not receive any of the rights of a minority shareholder. From the employee’s
perspective, SARs may be less attractive because of their ordinary income tax consequences and the
perception that the company is not willing to give the key manager "true ownership."
Phantom Stock Plans
Phantom stock plans derive their name from the fact that the executive is given "stock" of the
company as a bookkeeping entry but is not actually granted equity in the company. As a result, the
executive does not obtain the rights of a minority shareholder such as the rights to receive notice,
vote, and inspect books and records.
Common Features of Phantom Stock Plans
Although the structures of phantom stock plans vary, a few features are common to most of these
plans. Customarily, the company establishes a phantom stock account for the executive and credits
such account with fictional shares as they are granted or purchased. The company promises to pay
the value of all vested shares at a specified future date. Like SARs, phantom stock plans may be
settled in cash, stock, or some combination of the two.21
In their simplest form, phantom stock arrangements are not significantly different from
standalone SARs. If so structured, the value of each unit of phantom stock equals the appreciation in
the fair market value of the stock between the date the unit is granted and the date it is paid. Other
phantom stock plans attempt to replicate actual ownership by paying the value of the hypothetical
units granted at the settlement date. Some plans also pay dividend equivalents to phantom
stockholders when dividends are paid to the company’s actual stockholders. The phantom dividends
are taxable to the executive as ordinary income and deductible to the company.22 If the phantom
Doc: 131219/1/HM&B
1248211/1/13541.000
shares are used as part of a bonus plan, creative vesting schedules may be used in order to retain and
further motivate the executive.
Taxation of Phantom Stock Plans
The tax treatment that applies to SARs generally applies to phantom stock plans.23 Thus, executives
are taxed at ordinary rates on phantom stock awards at the time the awards are actually or
constructively received in stock, cash, or both.24 The company is generally entitled to a deduction in
the same year the executive declares income and is also subject to withholding requirements.
Advantages and Disadvantages of Stock Plans
For closely held corporations that desire to offer executives the opportunity to share in the
company’s success without giving them an actual equity stake in the company, phantom stock plans
provide ideal flexibility. The company may utilize creative measuring criteria and vesting schedules
that act as golden handcuffs to retain valued executives and align the executives’ interests with those
of the company. Furthermore, the company can offer economic compensation to its executives
without the burden of the obligations owed to shareholders.
The only potential negative associated with phantom stock plans are the executive’s
perceptions regarding true ownership versus economic equity and compensation that leads to
ordinary income as opposed to capital gains.
Performance Unit Plans
Whereas most incentive compensation plans base the plan’s economic reward on the overall
performance of the company, a performance unit plan uses a more specific measurement such as the
executive’s performance, the performance of the executive’s division, or the attainment of certain
targeted company goals that are directly related to the executive’s performance.
Common Features of Performance Unit Plans
A performance unit is benefit that is generally based on specified measuring criteria such as earnings,
sales, growth, production, return on equity, return on investment, profit margin, or other specific
measurements that the executive’s performance directly affects. Typically, the measurement is taken
over a period of time, providing an incentive predicated on long term results.
Under most performance unit plans, the company awards the executive a number of units that
are valued at a predetermined price at the beginning of a performance period.25 The number of
performance units may vary with performance, further rewarding exceptional performance.
Payments to the executive for some or all of the performance units is usually tied to the time the
performance goals are achieved. The company can structure the performance goals with time frames
Doc: 131219/1/HM&B
1248211/1/13541.000
that call for payments when certain levels are achieved and which are likely to be attained, virtually
ensuring the executive some additional compensation, and other thresholds that require outstanding
performance and provide greater compensation.
To enhance the retention elements of the plan, performance can be measured over long
periods of time. Golden handcuffs can also be created by establishing a deferred payment
mechanism or a vesting schedule, obligating the executive to work with the company for a specified
number of years following achievement of the awards or until retirement before payouts are
completed. Should the executive terminate his employment, the unpaid benefits can be forfeited.
Taxation of Performance Unit Plans
Performance unit plans are taxable to the executive and the company in the same manner as SARs
and phantom stock plans.26 Thus, the benefit is taxable as ordinary income to the executive when the
benefit is actually or constructively received and the company is entitled to a deduction when it pays
the benefit. The company is also subject to withholding requirements.
Advantages and Disadvantages of Performance Unit Plans
As long as a closely held corporation can create a defined plan with quantifiable goals, performance
unit plans will be among the most effective mechanism to tying benefits to performance. In addition,
the necessity of valuing company stock, which could adversely effect other shareholders for estate
and gift tax purposes, can be eliminated by using more readily ascertainable payment criteria.27
Performance unit plans may also better align the executive’s interests with the interests of
nonmanagement employees by linking the executive’s interests with the interests of nonmanagement
employees by linking the executive’s incentive compensation to the criteria that will be used as the
basis for bonuses to personnel under the executive’s charge.
Disadvantages of performance unit plans stem from the difficulties inherent in targeting
performance goals and designing a plan that will focus employees on attaining the desired results, the
potential deviation of the executive’s interests from the interests of the owners,28 a plan’s customary
lack of a capital investment requirement, and the fact that the executive is taxed at the historically
higher ordinary income rates.
CHOOSING THE RIGHT PLAN OR PLANS
Determining which plan a company should offer its executives is largely dependent on four
considerations: (1) The goals and objectives of the company; (2) whether the current shareholders
are willing to give up equity in the company and whether the executive desires to receive it; (3) the
effect of the plan on the company’s financial statements and the impact of various laws; and (4) the
needs of its executives.
With regard to considering the reasons for establishing the incentive plan and the features of
the various plans that will best achieve the company’s goals, the following questions must be
considered: Who should participate in the plan; when and how should the employees be paid under
the plan; should a capital investment be required by participants; should the plan require extended
employment with the company; what are the terms applicable to termination of employment; and
Doc: 131219/1/HM&B
1248211/1/13541.000
what benchmarks should form the basis for determining the amount of the compensation. The
answers to these questions will determine the most appropriate plan for the company.
For closely held corporations concerned that incentives are not directly tied to performance
by the individual are ineffective29 or may operate as a disincentives, performance unit plans offer an
ideal alternative. Entities desiring to align the interests of shareholders and executives will prefer
stock options or phantom stock plans that offer the identical upside for executives and shareholders.
Combinations of the various plans can be used to create a mix of incentives to direct and retain
employees.
Principal among the considerations is whether equity should be given to employees. Equity
plans contain tremendous advantages. For openers, equity offers the most effective means of
retaining an executive. Not only will the executive be less apt to leave the company because of his
ownership interest, but the tax consequences of a sale of the executive’s shares following termination
of employment makes competing offers less appealing. In addition, by providing the executive with
an interest similar to that of the shareholders, the company ensures that the executive’s efforts will be
channeled in ways that will increase the overall value of the company. Most importantly, the
corporation will preserve cash for investment and expansion.
Making equity available to executives, however, may create additional operational and legal
problems for the company–the company may be required to obtain the executive’s approval for
issuing additional equity, waiving preemptive rights, or engaging in major transactions. While these
rights can be reduced by the creation and use of nonvoting stock, the executive will still have rights
to notice, access to books and records, and benefit from the fiduciary responsibilities of others.
Finally, the company must develop a plan (i.e., a shareholder or buy-sell agreement) to reacquire
employee equity upon termination to avoid harmful actions by potentially bitter or hostile minority
shareholders.
The effects of employee incentive plans on financial statements and compliance with various
statutes such as ERISA and the Securities Acts may also be relevant. For example, the effect of
incentive plans on the income of the company may affect the company’s plans for outside financing,
a possible sale, or a public offering. Finally, the company should consider the needs of its executives
in designing incentive plans to properly motivate them.
A company should also consider combining equity-based and equity-like plans to take
advantage of the benefits of each type of plan. A common combination is that of an NSO with a
SAR. The company could require the executive to exercise the NSOs concurrently with payments
under the SAR plan, thereby providing the executive with cash to pay taxes, furnishing the company
with the executive’s funds to meet withholding requirements, and generating a deduction for the
company.
CONCLUSION
Incentive plans are effective tools for a closely held business to secure, motivate, and attract
executives as well as to join the interests of the executive with that of the company. Proper
structuring and implementation can enhance an entity’s well-being, preserve a successful
management team for years to come, and spur employees to reach new levels of performance. Given
Doc: 131219/1/HM&B
1248211/1/13541.000
the shortage of executive talent in today’s burgeoning economy, incentive plans may make the
difference in securing the personnel necessary to achieve maximum value and results.
i. Keith H. Berk and Jeffrey A. Hechtman are members of, and Kenneth A. Goldstein is associated with, the
Chicago law firm of Horwood Marcus & Berk Chartered. Copyright © 1998. Although this article focuses on
corporations, many of the concepts are applicable to other forms of entities. Keith H. Berk, Jeffrey A.
Hechtman, and Kenneth A. Goldstein. All rights reserved.
ii. I.R.C. § 422.
iii. Since it may be difficult for companies that are not publicly held to obtain a precise value of its
stock, § 422(c)(1) provides that this requirement is satisfied if a good faith attempt to value the stock
is demonstrated. This safe harbor does not apply to an individual who holds more than 10 percent of
the voting stock.
iv. This requirement is waived if, at the time the option is granted, the option price is at least 110
percent of the FMV of the stock and the option is exercisable within five years of its grant. In
addition, the determination of whether the employee owns 10 percent or more of the company is
made without regard to any unexercised options held by the employee. Prop. Reg. § 1.422A(2)(h)(l)(i).
v. A good faith attempt to value the stock may be sufficient. I.R.C. § 422(c)(5). See supra note 2.
vi. While the difference between the fair market value of the stock and the exercise price is not
subject to tax when the option is exercised, it is an item of adjustment that must be taken into
account when calculating the federal alternative minimum tax. I.R.C. § 56(b)(3). Therefore,
depending on the mix of the employee’s income, exercise of the option could result in AMT.
vii. The right to receive property (other than cash) must be includable in income under § 422(c)(4).
8. I.R.C. § 83(a).
9.I.R.C. § 83(e)(4).
10. The regulations explain that the value of an option is not readily ascertainable unless the option
is actively traded on an established market. Clearly, this is a condition that a closely held corporation
Doc: 131219/1/HM&B
1248211/1/13541.000
could seldom satisfy. In the alternative, the NSO may have a readily ascertainable fair market value
if it meets each of four separate conditions: (1) the option is transferable by the optionee; (2) the
option is exercisable immediately in full by the optionee; (3) neither the option nor the underlying
stock is subject to any restriction or condition, other than a condition to secure the payment of the
purchase price, which has a significant effect on the option’s fair market value; and (4) the fair
market value of the option privilege itself–as distinguished from the underlying stock– is readily
ascertainable. Reg. § 1.83-7(b).
11. Reg. § 1.83-1(a).
12. I.R.C. § 83(h).
13. I.R.C. 162(a)(1).
14. The stockholders, of course, do not pay for such benefit in the form of dilution in the value of
their shareholdings.
15. Only common law employees of the company, its parent, or subsidiaries are eligible for ISO
treatment. I.R.C. § 422(a).
16. The plan may provide voting and dividend rights for the unvested shares.
17. I.R.C. § 83(b).
18. Such a plan differs from an Employee Stock Purchase Plan under § 423. Among the
requirements of § 423 are that the plan, with limited exceptions, be open to all employees of the
company.
19. SARs issued by closely held corporations will rarely result in the company’s actually issuing
stock.
20. I.R.C. § 61(a)(1); Rev.Rul. 80-300, 1980-2 C.B. 165. If restricted property or stock is received,
then § 83 will govern its taxation.
21. For closely held companies, most phantom plans do not provide the option to receive stock
because such companies do not want to give up equity in the company.
22. Such dividends can be paid in cash or in the form of credits to the executive’s phantom stock
account. If the agreement is properly drafted, the executive will avoid taxation on these dividend
equivalents until they are actually received, just as taxation is deferred on the underlying grants.
23. LTR 9040035.
24. If restricted stock is received then § 83 will govern its taxation.
Doc: 131219/1/HM&B
1248211/1/13541.000
25. Thus, the maximum compensation charge to be borne by the corporation for the period of
service is known in advance.
26. LTR 8043060.
27. Of course, the achievement of performance goals must still be monitored and valued, but the
measurement of the performance criteria is likely to be less burdensome than the determination of
share value.
28. One reason why the equity and equity like incentives are so popular is that shareholders are most
concerned with appreciation in their stock holdings, while achievement of performance goals operate
merely as an indirect factor in share value.
29. An executive may have had outstanding performance, but the value of the company stock
depreciated for some other reason. Conversely, the executive may have performed below average,
yet he still receives a windfall as a result of superior performances by others.
Doc: 131219/1/HM&B
1248211/1/13541.000