9/29/2014
Alternative Approaches to
Executive Compensation
2014 New England Chapter Annual Conference
October 3, 2014
Bill Enck, CPA, CPC, APA
BerryDunn
Joseph E. Marx, CPA
Principal Financial Group
Today’s Agenda
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Designing an Executive Compensation Program
General Principles
Forms and Benefits of Long-term Incentives
Statutory Requirements – 409(p) & 409A
Working Together to Design an Executive Compensation Program
Other Considerations for ESOP Companies
Best Practices and Conclusions
Designing an Executive Compensation
Program
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General Principles
Consider Balance Between:
• Total cash compensation (e.g., salary and annual performance
bonus), and
• Long-term incentive compensation (typically intended to be
realized more than a year into the future)
Benefits of Long-Term Incentive
Compensation
• The four “R’s”
o Retention
o Recruitment
o Reward
o Retirement
• Alignment of management interest with the shareholders (the
ESOP)
• Motivates performance to achieve targeted financial objectives
• Wealth accumulation based on financial performance
• Targeted to key employees
Common Practices - LTIP Designs
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Common Practices –
LTIP Prevalence by Revenue
Survey Source
ZweigWhite A/E/C Incentive Compensation Survey
PFG Survey of Majority S Corp ESOPs > 500 Participants
NCEO 2011 Survey Exec. Comp. in ESOP Companies
Percentage Revenue
Offering LTIP
Median Rev. $7M
26%
Median Rev. $355M
67%
Rev. $0M ‐ $10M
21%
Rev. $10M ‐ $50M
31%
Rev. $50M ‐ $200M
45%
Rev. Above $200M
64%
LTIP for NCEO purposes is any actual equity award, equity-based award or deferred
compensation.
Forms of Long-Term Incentive
Compensation
• Pure Equity Awards
o Full value awards
 Stock grants (outright or restricted)
o Appreciation awards
 Stock options (qualified or non-qualified)
• Equity Based Awards
o Full value awards
 Phantom stock
o Appreciation awards
 Stock Appreciation Rights (SARs)
 Performance stock based upon specific metrics
Stock Options
• Incentive Stock Options (ISO)
• Nonqualified Stock Options (NSO)
• Employee Stock Purchase Plan (ESPP)
o Code Section 423
o Broad based option plans
Each has different tax ramifications
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Nonqualified Stock Options
Any option that does not meet the ISO requirements
• Accelerated taxation to recipient
• Ordinary income tax rates apply to some portion
• Creates a transfer of ownership (minority interest)
• Tax deduction for employer at Grant or Exercise
Date (must withhold tax)
• More design flexibility (not subject to ISO
requirements)
• No AMT exposure for recipient
• Can be awarded to anyone providing services
(not just employees)
Nonqualified Stock Options
Taxation to Employee
Company
stock
Taxable event
for recipient
(capital gains)
Sale of
stock
Grant
stock
option
Holding
period
Vesting
period
Exercise
option
Tax event for
recipient if FMV
determinable
(ordinary income)
or if employee
makes 83(b)
election
Taxable event for recipient if
FMV at grant date was not
determinable (ordinary income)
Nonqualified Stock Options
Employer Accounting
Employers need to withhold tax when the ordinary income tax
event to the employee occurs
Book – recognize
compensation expense
over vesting period
Tax – tax deduction when
taxable event to the
employee occurs
Creates temporary
difference
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Synthetic Equity
Nonqualified deferred compensation plans that provide benefits
to employees based on hypothetical shares of company stock.
• High flexibility provides for a number of
variables (who gets what, how much, vesting,
restrictions, etc.)
• Accounting can be complex
• Value of company’s equity must be defensible
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Flexibility
No actual transfer of ownership required
Less restrictive than other types of plans
Company does not have to have stock
Tax deduction for employer
Phantom Stock
• Promise to pay a bonus equal to value of
company shares
• Reward past and future services
• May reflect dividends and stock splits
• Ordinary income for employees
• Can be paid in cash or shares
• Vesting can apply
Stock Appreciation Rights
• Promise to pay a bonus equal to the
increase in the value of company
shares over a period of time
• Reward future performance
• Can be paid in cash or shares
• Vesting can apply
• Ordinary income for employee
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Synthetic Equity
Taxation to Employee
Company
Taxable event for
employee (ordinary
income – difference
between
consideration, if Distribution/
Payment
any, and FMV)
Non-taxable
Grant award event for
employee
Vesting
period
EXAMPLE
• Employee A granted 10,000 phantom stock
units on 1/1/20X1
• Employee B granted 10,000 SARs on
1/1/20X1
• Vesting over 5 years (1/1/20X6)
• FMV $7/unit at grant date
• FMV $10/unit at vesting date
• Benefits paid on 1/1/20X8
(FMV $12/unit)
Synthetic Equity – Phantom
Stock Benefit
Total income to employee = $120,000
Selling price ($12)
All Income is Ordinary income
• No tax at grant
• Employment tax at vesting
$120,000
• Income tax at distribution
• Employer – tax deduction
Ordinary income
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Synthetic Equity – Stock Appreciation
Rights (SARs)
Total income to employee = $50,000
Selling price ($12) less exercise price ($7)
All Income is Ordinary Income
• No tax at grant
• No tax at vesting
$50,000
• Employment and income tax at
distribution
Ordinary income
• Employer – tax deduction
Synthetic Equity
Employer Accounting
Book: Recognize compensation
expense from grant date through
exercise (vesting period)
• Reflect additional “shares”
Tax: Tax deduction when
exercised by employee
Creates temporary book-to-tax
difference (deferred tax asset)
• Adjustments in value
S-Corp ESOP Concerns
S-Corp ESOP plans must consider the IRC §409(p) allocation
rules
• §409(p) prohibits improper allocation during a nonallocation year by or
to a disqualified person.
• Synthetic equity treated as outstanding, deemed owned shares, if
Such treatment results in
• a disqualified person, or
• a nonallocation year
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S-Corp ESOP Concerns
S-Corp ESOP plans must consider the IRC §409(p)
allocation rules
Terms used by 409(p):
• Nonallocation year: Disqualified persons own at least 50% of the
number of shares of stock (incl. deemed owned)
• Disqualified person
o Family: At least 20% of number of deemed owned shares of
S-Corp stock
o Individual: at least 10% of number of deemed owned shares
of S-Corp stock
• Deemed owned shares: A person’s share of allocated and
unallocated ESOP shares
S-Corp ESOP Concerns
What Constitutes “Synthetic Equity” for §409(p)?
• Equity-based deferred compensation programs
o Stock appreciation rights, phantom stock, restricted stock units
and other programs based on future value of underlying stock
o Stock options, warrants, and restricted stock
o Deferred compensation arrangements
S-Corp ESOP Concerns
The Impact of §409(p)
• §409(p) imposes a 50% excise tax on a “prohibited allocation” of
stock in ESOP to disqualified person and value of “synthetic equity”
owned by disqualified persons
o Tax is imposed on fair market value of deemed-owned shares
held by ESOP for a disqualified person
• Prohibited allocations are treated as distributions and included in
income of disqualified person
• ESOP status will be lost if prohibited allocation occurs
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§409A Requirements
• Equity-based awards may be subject to §409A
o Phantom stock
o Discounted SARs and stock options
• Short-term deferral exception
• Timely payment is critical – late payment of such an amount is
automatic violation of §409A if plan does not provide a fixed
date/year by which payments are to be made
§409A Requirements
• The plan must specify the amount, time and form of payment of
deferred compensation
• The plan must generally not permit acceleration of the time or
schedule of payments under the plan
• The plan must generally not permit delay of the time or schedule of
payments under the plan unless certain requirements are met
• Acceleration of vesting of deferred benefits is permitted provided it
does not change the payment schedule
§409A Requirements
• If deferred compensation fails to comply with §409A:
o Deferred compensation is included in income
o Penalty tax on employee of 20% of amount included in income
(§409A penalty tax)
o Interest is assessed on the tax underpayments (at
underpayment rate plus 1%)
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Working Together to Design an
Executive Compensation Program
Who Designs the Executive Compensation
Program (Corporate Governance Issues)
• Determination of compensation is primarily a board function
o Delegation to committee is common
• Board members may be conflicted
o Wearing multiple hats?
 Also officer? ESOP trustee?
Corporate Governance Issues –
Addressing Conflict of Interest
• The Board has duty to act in best interests of Company
shareholders (shareholders elect the Board) but may face multiple
conflicts of interest in designing executive compensation programs
• Interested/conflicted Directors may desire outside review or to have
the shareholders approve the compensation arrangement
• Have a compensation committee comprised of independent
directors make the determination
• Involve a compensation consultant
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Implementing Executive Compensation
Arrangements – How is the ESOP Involved?
• Trustee may be asked to review the Board’s implementation of an
executive compensation arrangement
o Corporate governance concerns may be compounded if there are internal
trustees
• If the ESOP trustee is asked to approve the arrangement, it may
want the advice of a compensation consultant
• Trustee must be aware of its responsibilities:
o Trustee represents ESOP’s interest as a shareholder
o Trustee’s duty as an ERISA fiduciary is to act solely in the interests of
ESOP participants and beneficiaries
o Fiduciary prudence – review/monitor the impact of executive compensation
arrangements
• Check the purchase agreement from your ESOP transaction - there
may be limitations
Prudent Reviewing/Monitoring Executive
Compensation Arrangements
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How was the amount of compensation determined (e.g. use of an
independent compensation consultant)?
How were performance incentive goals determined (e.g. input from
compensation consultant, accountants, attorney, financial advisor to
ESOP)?
Are the performance incentive goals consistent with:
o Company’s business plan for long-term growth (discrepancy between
goals and business plan are problematic)?
o Cash flow projections applied in annual valuation?
Have any non-competition/non-solicitation provisions been negotiated?
Are there any “2nd Class of Stock” concerns? (S Corp)
What happens in the event of a change-in-control?
Does the arrangement comply with 409A? (Attorney)
How is the plan modified/amended?
Trustee Focus in Reviewing Executive
Compensation Arrangements
• Properly designed arrangement creates a “win-win” for both key
management personnel and ESOP participants
• An effective design will achieve the following:
o Entitlement to benefits comes from achieving real, measurable
performance goals
 Benefits should be EARNED
o Satisfaction of performance goal(s) drives growth in Company stock
value and offset any economic dilution of ESOP shares
o Aggregate compensation paid to key management personnel is
reasonable, yet competitive (analytical support from compensation
consultant)
o Long-term retention of key management personnel
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Analysis of Economic Dilution
• Comparison of economic dilution vs. projected increase
in value
• Dilutive impact should not be “unfair” to ESOP
• Analysis performed with assistance/input from financial
advisor, attorney, and compensation consultant
Dilutive
Impact
Projected
Increase
in Value
Additional Concerns
• Understand impact of arrangement on annual valuation
short-term vs. long-term
• Implementation in transaction
o Negotiations can impact the final terms of the plan/arrangement
o May see less sharing of analysis from fiduciary
• Non-transaction implementation
o Focus on conflicts of interest
o Successor trustee issues reviewing previously established plan
• Obsolescence of plan/arrangement
o Unforeseen circumstances (e.g. significant downturn in economy)
o Amendment and redesign concerns
• Impact on repurchase liability, corporate acquisitions
• Communicating to ESOP participants
Best Practices - Understand the Impact
on Valuation
• LTIP cash outflows will impact share value, and share value,
in turn, affects LTIP value.
• Appraiser should help value the LTIP (for appreciation
awards like SARs or options)
Otherwise, you may under-grant or over-grant
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Best Practices (cont’d)
LTIP and Repurchase Liability Studies
• Conduct an interactive repurchase study that involves your
financial advisor
• Include both the ESOP and executive compensation programs
(both are often unfunded)
• Do iterative analyses that consider cash outflow for both
obligations and resulting outstanding shares
Best Practices (cont’d)
Consider the ESOP
• Most executives appreciate the ESOP intangibles
• What about their ESOP account?
o Are they barred/capped in the ESOP?
o Do they appreciate the true benefit?
o Benefits benchmarking is difficult and hard to personalize
o Retirement income replacement ratios are one objective proxy
for retirement adequacy
Conclusions
• Properly designed compensation plans help align the economic
interests of management and the ESOP
• If performance based, equity incentive compensation plans are not
immediately dilutive to the ESOP and are only related to future
appreciation
• Best performance-based measures are:
o Achievement of certain financial benchmarks (i.e., revenue and
profitability)
o Debt repayment
• The value of the equity holders’ interest is diluted by the value
allocable to the derivative security
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QUESTIONS?
Bill Enck, CPA, CPC, APA
Berry Dunn
[email protected]
(207)541-2300
linkedin.com/in/billenckcpa
Joseph E. Marx, CPA
VP - ESOP Consulting
Principal Financial Group
[email protected]
(716)710-4134
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