Want to Keep the Best Execs? Use Incentive Compensation Plans

October 30, 2017

Are your senior executives thinking like business owners? If not, there’s probably room to improve your incentive compensation plans.

While annual incentive bonus plans are fine for emphasizing short-term priorities, odds are you’re looking further down the road — and your top executives should be, too.

Fortunately, you have alternative options. Start by reviewing your incentive compensation plans, as the right plans will motivate key employees to think strategically and make decisions based on the long-term impact for shareholders.

While traditional stock options plans are commonly used as a long-term incentive plan, lately phantom stock or stock appreciation rights (SARs) are becoming more common.

Phantom Stock and SARs

Phantom stock and SARs plans are essentially the same functional incentive with different names. Similar to a stock option, an SAR can have the same economic value of a stock option, but the employee will not actually ever have the right to become a shareholder.

SARs work like stock options: Their value is pegged to appreciation of the underlying stock.

Similar to a stock option, the typical SAR grant will feature a vesting schedule and an inherent strike price. An SAR is most beneficial for the following situations:

  • The company does not want the employees to become actual shareholders;
  • The company wants to establish a goal of only rewarding employees with a paid incentive if they are employed when a particular event occurs, such as sale of the company or retirement, death or disability of the employee.

“This stock-like program provides the opportunity to share in the value created in the total enterprise, and in doing so, it also helps create value for our policyholders,” said a MassMutual spokesman about phantom stock benefits in The Boston Globe.

Generally, SARs are forfeited if the executive quits, is fired for cause or violates a non-compete agreement. SARs provide maximum flexibility surrounding all of these areas and can differ by employee award.

An SAR is a non-qualified deferred compensation plan which is governed by IRS Section 409A of the tax code, rather than the Employee Retirement Income Security Act (ERISA). The latter governs traditional benefit plans designed for large groups of employees. Since Section 409A doesn’t tie your hands as much as ERISA, design allocations to avoid having them deemed an ERISA plan.

There are big tax benefits involved, and the basic tax rules run as follows:

  • Taxation of the value of phantom stock awarded to executives doesn’t occur until the executive receives payment, when it’s taxed as ordinary income.
  • The company receives a tax deduction equal to the amount of income recognized by the employee.
  • The value of the granted phantom stock is subject to the Federal Insurance Contributions Act (FICA) and Medicare taxes as it vests.
  • S Corporations should consider using SARs in lieu of stock options, so employees will not have to receive K-1s and so non-U.S. employees cannot put the S election at risk.

Decisions, Decisions

You have flexibility in designing phantom stock and SARs plans, so you’ll need to decide:

  • Which executives will the plans cover?
  • What is the economic value you’re hoping to award over various periods?
  • If you have an existing stock option plan, does it already contain provisions whereby you can award SARs? Generally, we advise companies to have a flexible stock option plan which allows the award of SARs, incentive stock options (ISOs) and non-ISOs.
  • How many units will you award, and how often?
  • What vesting schedule will you use? (You have complete flexibility here, unlike with ERISA plans.)
  • Will you fix the value of shares?
  • How will you fund the liability you’re accruing as these future cash payment obligations grow?

A Question of Funding

Two common funding approaches are corporate-owned life insurance (COLI) and a rabbi trust.

COLI contracts can be designed with cash accumulation features around the accruing phantom stock funding liability, along with the added promise of a death benefit that would address a sudden triggering of that liability should a covered executive die prematurely.

The rabbi trust, which is also used to fund other kinds of non-qualified executive compensation plans, is a repository for regular cash contributions (and is not tax-deductible). The accumulating cash and earnings in the trust fund the phantom stock plan liability, and can’t be diverted to other purposes except to creditors in a corporate bankruptcy.

Creating phantom stock and SARs programs take thought and administrative or legal expense. They require you have key executives you want to keep for the long haul. By offering the right incentive plans, you’ll be more likely to motivate them to improve the value of your organization.

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