Alternative Approaches to Executive Compensation

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 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 1

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 2

Common Practices LTIP Prevalence by Revenue Survey Source Revenue Percentage Offering LTIP ZweigWhite A/E/C Incentive Compensation Survey Median Rev. $7M 26% PFG Survey of Majority S Corp ESOPs > 500 Participants Median Rev. $355M 67% NCEO 2011 Survey Exec. Comp. in ESOP Companies 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 3

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 Taxable event for recipient (capital gains) Sale of stock Company stock Grant stock option Tax event for recipient if FMV determinable (ordinary income) or if employee makes 83(b) election Holding period Vesting period Exercise option 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 4

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 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 5

Synthetic Equity Taxation to Employee Company Taxable event for employee (ordinary income difference between consideration, if any, and FMV) Distribution/ Payment Grant award Non-taxable 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) $120,000 Ordinary income All Income is Ordinary income No tax at grant Employment tax at vesting Income tax at distribution Employer tax deduction 6

Synthetic Equity Stock Appreciation Rights (SARs) Total income to employee = $50,000 Selling price ($12) less exercise price ($7) $50,000 Ordinary income All Income is Ordinary Income No tax at grant No tax at vesting Employment and income tax at distribution Employer tax deduction Synthetic Equity Employer Accounting Book: Recognize compensation expense from grant date through exercise (vesting period) Reflect additional shares Adjustments in value Tax: Tax deduction when exercised by employee Creates temporary book-to-tax difference (deferred tax asset) 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 7

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 8

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%) 9

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 10

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 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 2 nd 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 11

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 12

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 13

QUESTIONS? Bill Enck, CPA, CPC, APA Berry Dunn benck@berrydunn.com (207)541-2300 linkedin.com/in/billenckcpa Joseph E. Marx, CPA VP - ESOP Consulting Principal Financial Group marx.joseph@principal.com (716)710-4134 14