At Quorum, we’re committed to financial literacy, and that doesn’t just mean for individuals. Whether you’re a top executive at a larger company or an entrepreneur growing a startup and wondering what tools you might have at your disposal, there are numerous compensation options to consider. In this article, we’ll provide an overview.
Whether any of these options may be right for your firm depends on multiple factors; we suggest you consult with financial, legal, and tax professionals before implementing any of these strategies. For an employee-centric view of these topics, read our article on equity-based compensation.
Restricted stock
Restricted stock units (RSUs) are one of the more common forms of equity compensation we encounter. With restricted stock units, the company grants employees shares in the company that they’ll receive following a vesting period, which may include certain conditions.
Companies might also consider issuing restricted stock awards (RSAs). These shares are technically awarded when granted, but they still follow a vesting period during which the shares can be forfeited or rescinded pending certain conditions.
What to consider before issuing restricted stock
Issuing restricted stock comes with pros and cons. On the pro side, you are granting an actual ownership position to the receiving employee, meaning you (as an employer) can receive a tax deduction for the labor expense. On the con side, the terms included in vesting agreements can become complicated. Plus, issuing stock can lead to share dilution both in terms of equity ownership and voting rights.
To remedy this, companies consider phantom stock, which operates like an RSU in principle, but instead of awarding shares at vesting, the employee is paid a cash equivalent. To mimic RSAs, companies could use stock appreciation rights (SARs). With SARs, you grant employees a hypothetical number of shares and provide a vesting date and terms. On the exercise date, you would pay the employee a cash equivalent for however much those hypothetical shares have increased in value.
What to tell your employees
Both RSUs and RSAs are taxed as ordinary income when they vest. However, employees can file an 83(b) election with the IRS saying they’d prefer to pay taxes on the value of their shares when granted versus when vested. This can be a great strategy if the employee expects the shares to increase in value dramatically during the vesting period, as with a growth-oriented startup.
However, it does carry risk. If you forfeit your shares before vesting, or if the shares decrease in value, the IRS does not issue refunds. Additionally, any vested shares start accruing potential capital gains tax as soon as you pay the income tax due on their issuance.
Employee stock options and purchase plans
You give your employees the right to purchase shares at a set price (the value of the shares at the date you grant the options) within a specified timeframe (an exercise window following a vesting schedule). Usually, these options vest based on time or performance criteria—once the options vest, the employee has a specified window of time to exercise the options.
What to consider before offering stock options or purchase plans
There are two primary categories of stock options firms can offer employees:
Non-qualified stock options (NSOs) include tax benefits for the issuing firm and can be used more loosely—with consultants and key partners, as well as employees.
Incentive stock options (ISOs) don’t carry immediate or obvious tax benefits for the company. Additionally, you can only issue $100,000 worth of ISOs per employee per year (and they are only available to employees). Finally, ISOs can carry a higher administrative burden for the company. However, ISOs can inspire long-term commitment from key hires and can be an attractive compensation option if you anticipate a big exit or IPO.
In either case, be prepared to generate and document the fair market value for any stock options both at the time of grant and at the time the shares are exercised. Additionally, consult with an attorney about potential 409A complications to make sure you (and your employees) are fully versed in the potential risks.
For established companies who want to offer employees a chance to own shares without granting them restricted stock, employee stock purchase plans (ESPPs) may be an option. These plans allow your team to withhold a portion of their paycheck to buy company shares at a discount of up to 15%. These plans may come with tax perks for the company and tax rules that employees must observe.
What to tell your employees
The tax ramifications for employees can be complex, and the capital required to purchase the options can present hurdles (particularly if you’re offering options to offset lower cash-based compensation).
If you’re offering ISOs, make sure your team understands the alternative minimum tax (AMT) and potential cash flow issues that could arise depending on how they handle their options.
With NSOs, make sure your employees understand what qualifies as ordinary income and is taxed at exercise, and what might qualify for capital gains tax later on.
Similarly, make sure any employees enrolled in an ESPP understand potential penalties and tax restrictions on shares they purchase through their arrangements.
Deferred compensation plans
Nonqualified deferred compensation (NQDC) plans are an infrequently used, yet very powerful benefit option employers can use to recruit top talent. These deferred comp plans are particularly attractive to established execs who find themselves in high income brackets. Essentially, with NQDCs, select employees may elect to have a portion of their salary (taxable income) paid at a future date, instead of the year they earn it.
What to consider before offering deferred comp
The IRS allows you and your employees significant flexibility when it comes to setting up and using a deferred compensation plan. For instance:
- There is no limit on how much taxable income qualifying employees can defer.
- There’s no age restriction on distributions.
- Distributions can be made in various ways (lump sums versus installments).
- The money grows tax deferred within the deferred comp plan.
With NQDC plans, you (the employer) do not need to immediately fund the plan. In other words, you don’t have to pay the employees deferred salary into the plan the year they earn it. Instead, you issue an unsecured promise to pay this amount in the future. Additionally, the assets in the plan remain on the company balance sheet until distributed, at which point they qualify for a tax deduction. Prior to that, you’ll be taxed on investments within the plan. The plan itself is unfunded and secured by the general assets of the company, meaning the plan could be vulnerable to creditors if insolvency ensues.
What to tell employees
Many of the top executives who qualify for deferred comp will want to consider it as part of a broader financial plan and tax strategy. We go into more depth on the details they may want to look into in this article.
Before you implement any of these plans
If you’re considering these types of compensation packages, there’s a chance that you yourself are a top executive who may qualify for them. This raises an important point around insider trading and pertinent restrictions.
Employee stock transactions may come with contractual restrictions as part of the SEC Act of 1934 (specifically, under rule 10b5). This prohibits investors who have material nonpublic information from selling shares. Typically, you’ll want to develop a company policy that reflects this rule and enforces a blackout period on selling shares, usually tied to key dates, such as quarter end, regulatory filings, earnings reports, or similar.
Even if an employee’s shares don’t fall under SEC regulations, you may be able to apply lock-up provisions for employee shares. For instance, many companies prohibit affiliates from selling shares and/or any derivative trading for several months after a company IPO or buyout.
Other rules you might consider as a company include a ban on short selling or derivative trading on company shares.
If systematic selling becomes difficult for insiders due to blackouts, material nonpublic information, or market signaling, we recommend working with an attorney to create a proactive Rule 10b5-1 trading plan. This will create a proactive defense against any potential allegations of insider trading. Additionally, that same attorney can help you create rules and restrictions tied to any equity- or incentive-based compensation. It’s important to ensure the firm is protected even as you try to recruit top talent.
In addition to an attorney, we suggest working with a tax specialist and a wealth advisor—ideally one who advises corporate plans and understands the needs and concerns of the employees you’re targeting with these offers.
At Quorum, we work with both companies and top-level executives to administer and/or optimize complex compensation packages. If you have additional questions about how any of these (or additional tools not mentioned in this article) might apply to your firm, please schedule a consultation.
