Non Salary Employee Compensation

Employers who hope to retain key employees are increasingly turning to stock options, restricted stock, SARS, phantom stock, performance units or other non-salary compensation in order to accomplish that employee retention. This article defines and discusses the most common forms of non-salary compensation.

In its simplest form a stock option is the right to buy stock in the future at a price which is fixed in advance. The pre-determined price of the shares is called the strike price. The idea is for a company to grant an employee the right to purchase shares at for example $20 per share, after three years from the grant of the option, no matter what the stock's fair market value is at that later time. Because options are only exercisable in the future, i.e, when they "vest", companies routinely use stock options to retain key employees. Stock options may be either incentive stock options or non - qualified stock options.

An incentive stock option, or ISOs, is a stock option which is tailored to take advantage of Section 422A of the internal revenue code. An ISO results in special tax consequences for both the employee and employer. For an employee, there is no income when the ISO is granted or when the option is exercised. Instead, the employee recognizes gain when he or she actually sells the shares, and any appreciation in value from the grant to the date of sale is treated as long term capital gain if the stock is held at least one year from the date of exercise and two years from the date of the grant. In order for a stock option to qualify as an incentive stock option, the plan must be in writing and be approved by the board of directors and the shareholders of a company. In addition a company cannot amend such a plan without destroying the tax benefits thereof, and the options can not have an exercise date beyond 10 years from the date of the grant. Any corporation intending to develop an incentive stock option plan should consult a tax attorney.

A non - qualified stock option is one which does not comply with the rules for ISOs set out by the IRS and are therefore much more flexible than ISOs. From an investor's standpoint, it is important to remember that stock options are not charged against current earnings when they are granted. This is true as long as the ratio of the option price to the fair market value at the time of grant is at least 1.00. However, when the employee option holder later exercises the option, the company must provide him or her with the shares, even if the market price at exercise is much greater than the exercise price. Thus, according to current Financial Accounting Standard Board Rules, companies are incurring liabilities for employee compensation without taking a current charge against earnings, and investors who do not read the fine print are missing the real financial picture. Also, when options are exercised, they often have the effect of diluting the current value of the existing shareholders.

Restricted stock are shares given to employees that are subject to restrictions which prevent the employees from selling the stock until certain conditions are met. For example, the shares can be "given" now but not sellable by the employee until he or she works at the company for five years, or they can be restricted until performance objectives such as a sales goal are met. Generally, the employee recognizes no income at the time of grant of resticted stock, but the employer must recognized a charge against earnings. The employee is taxed for ordinary income at the time the shares vest, i.e, when the restrictions are removed. However, employees do have the right to make a section 83(b) election in which case they do pay tax as ordinary income on the fair market value of the restricted stock when it is granted, but then pay tax on any appreciation at a capital gains rate, which is lower than that for ordinary income. If the share price goes down from the time an 83(b) elector pays the tax and the shares vest and are sold, the employee has wasted money, because there is no opportunity to change the election after it is made.

Another method of paying employees non-salary compensation is are "SARs", or stock appreciation rights. A SAR is a contract which gives the employee recipient the right to compensation based on the increase in value of company stock. The actual compensation can be paid in cash or stock.

Phantom stock plans are contracts between employers and employees whereby employees are granted imaginary shares or units. These units track the employer's shares and when the units vest the employee has the right to the value of the unit at the time of grant (which distinguishes phantom stock from SARS) and any appreciation which has taken place in the meantime.

Performance units or performance shares are phantom stock which instead of being tied to the price of the employer's shares, are tied to the attainment of specified company goals, such as meeting a sales target.

For small business owner, stock option plans are often not appropriate. First, these plans get very complicated very quickly, and when the employees do not understand the plan there are likely to be disappointed expectations and lawsuits. Problems are often causued by misunderstandings about the value of the option plan or by mistakes in the plan itself which lead to unintended tax consequences. Additionally, stock option plans which place stock with employees make the employees owners. Employee owners, even those with a minority interest, have rights in corporate governance that non-owner employees do not. For these reasons traditional bonus or commission programs are often the best alternative to adopting some complicated and expensive scheme that no one really understands.