How to Incentivize Plans for Employee Retention

MIKE KIRKMAN: Welcome to Cherry Bekaert's Private Client Service Podcast, where we discuss tax, accounting, and business matters impacting your business and personal growth goals to help guide you forward to achieve your financial objectives. I am Mike Kirkman. I'm a partner with Cherry Bekaert, and I lead our firm's estate, gift, and trust practice.

MIKE KIRKMAN: Today with me is Deb Walker, our firm's national leader of compensation and benefits. We're discussing incentive plans and how businesses retain and keep talent. Deb, considering so many industries are experiencing labor shortages, what effective arrangements have you seen that help attract and keep key personnel?

DEB WALKER: The most effective are annual performance bonuses. Those are beneficial because they reward people who meet specific, well-understood performance goals, and they are paid only when those goals are met.

DEB WALKER: There can also be equity-like plans. In private companies we see fewer true equity plans because owners often want to control stock ownership. Instead, we see equity-like plans that pay compensation equal to equity growth, though those require equity valuation and have complications. Overall, performance pay plans are the best way to go.

MIKE KIRKMAN: What are some straightforward ways business owners incentivize and retain employees?

DEB WALKER: Performance plans can be annual or longer-term incentive plans, or a combination of both. Generally, higher-level employees are more likely to be on long-term plans to focus executives on long-term growth, while lower-level employees may have quarterly plans tied to quarterly work.

DEB WALKER: Beyond salary, it's important to have the right fringe benefits. That includes 401(k) plans; Congress recently passed rules regarding starter 401(k) plans, increasing the credit for starting retirement plans and making plans easier to start. You can start them after the end of the year.

DEB WALKER: Employers should also offer health benefits or at least the opportunity to join a group plan, which is typically cheaper than an individual plan, and allow employees to pay on a tax-preferred basis.

MIKE KIRKMAN: Are there plans that allow key employees to own stock or an interest in a business, such as an LLC?

DEB WALKER: Yes. LLCs are often taxed as partnerships, and at the partnership level you can grant a profits interest. A profits interest gives the individual rights to future partnership value after certain hurdles are met. The IRS's position is that a profits interest has no liquidation value on the date it is transferred and therefore is not taxable at that time.

DEB WALKER: The profits interest becomes taxable as it vests and distributions are made. If you receive a profits interest in an LLC taxed as a partnership, you are treated as a partner for tax purposes, even if your capital allocation is zero; your salary would be reported as a guaranteed payment.

DEB WALKER: Alternatively, a capital interest transfers current equity value in the partnership and is taxed like a stock transfer. In a corporate context, you can receive stock, options, or stock appreciation rights. An option is the right to buy stock at a fixed price for a period of time. A stock appreciation right pays the spread between the stock value at exercise and a base amount, typically the value on the grant date.

DEB WALKER: Generally, when you receive equity—whether stock granted by the employer, stock from exercising an option, or a capital interest in a partnership—you are taxed on the value you receive minus any amount you pay. Taxation occurs when there is no longer a substantial risk of forfeiture, such as meeting service or performance requirements.

DEB WALKER: If the equity is subject to a substantial risk of forfeiture, you can either pay tax when the restrictions lapse or elect to pay tax at the date of transfer. If you do nothing, you pay tax when the risk of forfeiture lapses. If you make a Section 83(b) election, you pay tax on the value at the date of transfer.

DEB WALKER: For example, if shares are worth $10 today and you must work three years before they vest, making a Section 83(b) election means you pay tax on $10 today and your holding period for long-term capital gain begins. If you do not make the election and the shares are worth $25 when restrictions lapse, you pay tax on $25 as ordinary income.

DEB WALKER: The upside of a Section 83(b) election is potential capital gains treatment on later appreciation. The downside is that if you do not meet the vesting requirements, you do not get a refund of the tax you paid.

MIKE KIRKMAN: It sounds like individuals in these arrangements need a good tax advisor to evaluate potential capital gains versus ordinary income consequences. What if the business owner doesn't want to issue additional shares or profits interests?

DEB WALKER: Employers can offer phantom shares. A phantom share is a promise to pay an amount equal to the value of the stock without transferring equity. Phantom shares can be structured in many ways, such as a contract to pay a percentage of profits. That functions as a deferred compensation arrangement or an annual bonus tied to profits.

MIKE KIRKMAN: The goal in either situation is to keep key employees and incentivize them to help the business grow so they can share in the company's growth.

DEB WALKER: Yes. If you do transfer stock in a private company, you can include rights of first refusal, call options, and put options. Put options let the employee sell the stock back to the company, which could create a cash burden, but all those features can be built into plans.

MIKE KIRKMAN: Can you clarify the difference between an ISO and an NSO?

DEB WALKER: An ISO is an incentive stock option. An NSO, sometimes called an NQSO, is a non-qualified stock option. ISOs generally have more favorable tax treatment for employees but come with more rules, including limits on the amount that can vest in a year—typically no more than $100,000 becoming exercisable in any one year.

DEB WALKER: With an ISO, there is generally no compensation income recognized at exercise, so taxation is deferred unless the alternative minimum tax applies. If you hold the stock received on exercise for two years after the option grant and one year after exercise, gains are taxed as capital gains.

DEB WALKER: If you fail the holding period requirements, the ISO is treated like a non-qualified stock option and ordinary income is recognized. With an NSO, you recognize ordinary income at exercise, and capital gain treatment begins thereafter.

DEB WALKER: For employers, NSOs often provide a larger tax deduction because the employer's deduction equals the employee's compensation income. However, employees typically prefer ISOs for their potential capital gains treatment.

DEB WALKER: Since 2004, all ISOs and NSOs must have exercise prices equal to fair market value on the grant date. Discounted options are generally subject to penalty tax rules, which most people avoid, so we do not see many discounted options. If an option is granted with an exercise price below fair market value, it is not an ISO and will be treated as an NSO and subject to tax at exercise.

MIKE KIRKMAN: This is a lot of information, and it seems business owners have many options when designing incentive plans for key employees. It's clearly not one-size-fits-all, and decisions range from simple benefit plans to more complex arrangements.

MIKE KIRKMAN: Thank you, Deb, for explaining what you're seeing in the market. Thank you to everyone who joined us today. If you have questions, reach out to us at cbh.com/PCS, Private Client Services Group. Please join us for future podcasts.