Articles by: Richey May, Dec 07, 2022
How to attract and retain top lending talent
You need a compensation strategy that rewards top talent in meaningful, not just monetary, terms. A strategy that helps attract and retain the best employees while boosting morale is ideal for both the employer and the employee. In this blog post, we’ll tell you how to get there.
Four Key Considerations
Start by deciding what type of compensation plans you’ll offer: equity-based or non-equity. Essentially, the decision comes down to how much ownership you’re willing to give up.
Compensation plans also come with administrative burdens. How much administration can you afford to take on? Will you need to hire someone to help manage the plans or can you absorb the added responsibilities with existing staff?
Timing of benefits is another key consideration. Defer the benefit? And if so, for how long? What about vesting? Common vesting schedules are three to five years. What works for your firm, your market, and your bottom line?
Finally, consider how many employees will benefit and how much to offer. Qualified plans require extending benefits to everyone albeit in limited amounts. Non-qualified plans are unlimited but benefit only top performers or executives.
Four Equity-Based Options
If you’re leaning toward equity, your choices fall into four areas, each with its own set of pros and cons.
1. Restricted Stock. There are 2 types of Restricted Stock: Restricted Stock Awards and Restricted Stock Units.
- Restricted Stock Awards issue stocks Day 1 but are not vested. They treat awards as outstanding stock with voting rights. Any dividend paid is considered compensation before vesting. Or if vested, it’s compensation if no 83(b) election has been made.
- Restricted Stock Units are a type of stock compensation where no stock is being issued until vesting.
The 83(b) election allows employees to treat stock awards as regular wages versus waiting to vest. It comes with two potential tax advantages for the employee: 1) The compensation amount (value of the stock) may be much lower on the granting date than the vesting date. 2) Ownership begins with election, including dividends and long-term capital gain holding periods.
But there’s also a potential trap. Upon an 83(b) election, an employee receives the basis based on the value on grant date for future gain or loss on sale of stocks. If the stock loses value before selling, capital loss will be recognized and may have limited use. Furthermore, if the employee leaves before vesting, they won’t be entitled to any deduction or capital loss for the original compensation reported.
2. Stock Options. Stock options come in two flavors: incentive and nonqualified.
Incentive stock options allow employees to purchase corporate stock at an agreed-upon price within a specified time period (typically 10 years) subject to vesting of the option. Upon exercise, there is no income to the employee and therefore no corresponding deduction for the company (unless there is a disqualifying disposition (DD)). A DD occurs if the stock is sold by the employee before the later of (1) two years after the date of grant or (2) one year after the date of exercise. Upon a DD, it’s considered employee wages for the amount of unrealized gain on the exercise date and capital gain for amounts above that. The company takes a compensation expense as reflected on the employee’s W2.
Nonqualified stock options have a vesting period and may be granted to employees or non-employees. Must be issued with an exercise price equal to the stock’s fair market value (FMV) on the grant date; otherwise, there may be a potential Section 409A violation resulting in in penalties, including 20% penalty on acceleration of income (see Nonqualified Deferred Compensation Plan below).
Upon the grant date, there’s generally no income to employee or non-employee. Upon exercise, it’s treated as compensation via W2 or 1099-NEC (based on FMV of stock on exercise date above exercise price).
3. Employee Stock Ownership Plan (ESOP). An ESOP is a qualified defined-contribution employee benefit plan (ERISA) designed to invest in the stock of the sponsoring employer. ESOPs are often used as a corporate finance strategy and to align the interests of a company’s employees with those of its shareholders. Generally, they benefit a corporate employer that fits four criteria:
- Profitable and expects a profitable future
- Closely held with only a few shareholders but with payroll large enough to sustain contributions
- Substantial net worth and little debt
- Strong desire to boost morale and productivity
ESOPs have similar requirements to a 401k and other retirement plans, such as plan testing and nondiscrimination. All qualified plans are combined for testing purposes, and there are leveraged or unleveraged options. ESOPs also involve high administrative expenses.
ESOPs are available for C Corps and S Corps but offer C Corps additional benefits, including:Owners who sell stock to an ESOP may pay tax at the 20% long-term capital gains rate. If the company is a C Corp, the seller may be able to defer tax, perhaps even permanently. (But there are multiple requirements to obtain this benefit.)
C Corps can receive an interest deduction for dividends paid on stock held by an ESOP and used to repay ESOP debt.
Since S Corps cannot pay tax-deductible dividends, they may have to increase cash distributions to all shareholders to fuel ESOP funding. That, in turn, may affect the percentage of outstanding stock owned by shareholders.
Keep in mind that with ESOPs, employees receive ordinary income for distributions of cash or stock from the plan while the company can take a tax deduction for contributions of shares (or money to purchase shares). K-1 income allocated to the ESOP is tax-exempt. Employees receive ordinary income for FMV on termination/retirement date and stock must be repurchased by the company on such date.
4. Profits Interest (Partnerships). No initial equity upon issuance. Employees have a right to earn equity or receive an interest only on future profits.
Profits interest presents many benefits to the employer:
- Prior company value remains in the hands of current owners. (Note: You’ll need a valuation upon issuance of a profits interest to know the current value.)
- No upfront employee compensation as opposed to issuing a capital interest (however, no deduction for the employer)
- Profits interest can serve as a strong retention tool.
- Profits interest incents employees to boost the company’s profitability.
Six Non-Equity Options
If you’re not ready to give up ownership, a non-equity incentive compensation plan may make more sense. In this case, you have six choices, again each with its own set of pros and cons.
1. Nonqualified Deferred Compensation Plan (NQDC). The most complex of the non-equity options, NQDCs defer payment of compensation earned in one tax year to a subsequent year.
NQDCs can be extended to both employees and non-employees, though they can discriminate, conferring eligibility only to executives and key employees. If deferred compensation is paid after 2 ½ months post year-end, NQDCs require a written plan that complies with Section 409A of the IRS internal revenue code. (Note – if compensation is subject to a substantial risk of forfeiture, it is not yet earned and not subject to 409A.) Please note that NQDC plans:
- Deferred compensation is subject to company creditor risk
- Must provide payment date(s) that are “objectionably determinable and nondiscretionary” at time of deferral and cannot be accelerated with the exceptions of separation of service, death or disability, change in control, or unforeseeable emergency (per Treasury Regulations)
- May specify schedule of payments (i.e., 25% for four years after age 60 or separation of service)
Failure to comply with 409A can result in:
- Taxation of deferred amounts for the year of failure and all previous years
- 20% tax penalty to employee and interest on deferred compensation
- Payroll tax penalties for employer for improper reporting and late tax deposits
Note that failure to comply with 409A in one year does not adversely affect the taxation of amounts deferred in subsequent plan years that do comply. And keep in mind that plan failures in drafting or operation may or may not be eligible for plan correction.
2. Stock Appreciation Right (SAR). Aform of NQDC, a SAR is an employee bonus equal to the appreciation of a company stock over an established period that provides for vesting but must comply with 409A. It’s similar to stock options, but employees don’t have to pick up income upon exercising the option. Employees receive proceeds from stock price increases without a requirement to buy anything.
3. Phantom Stock/Unit Plan. Another form of NQDC, phantom stock offers a way to tie incentive compensation to increases or decreases in company value without awarding actual ownership. Vesting is permitted, but a few rules apply:
- The value of a phantom stock unit can be measured either by the value of a full share/unit of the company or by appreciation during a specific time (SAR).
- Payouts are typically deferred until a future date or the end of employment.
- The company must do appraisals or other form of valuation and lay out a plan that specifies which events trigger a valuation along with the timing of it.
4. Discretionary Bonus Plan. A compensation plan that awards bonus compensation above and beyond base salary and can be combined with NQDC.
5. Production Bonus Plan. A plan designed to drive individual and team production of units.
6. Qualified 401k Retirement Plan. A 401k plan features non-discrimination rules for elective deferrals and employer matching contributions. Employers must satisfy certain contribution, vesting, and notice requirements.
The bottom line: You have many options when it comes to a compensation strategy to attract and retain top talent. The right one is the one that will help gain tax efficiencies not just now but years from now. To learn more, call (303) 721-6131 to speak with a Richey May tax expert or email us at firstname.lastname@example.org.