Client Alerts
April 08, 2024

Key Employee Compensation Alternatives

Stites & Harbison Client Alert, April 8, 2024

Many companies struggle with how to best compensate and incentivize their key employees. Salary and short-term bonuses alone may not be sufficient. Many key employees seek to be rewarded for their long-term efforts and to share in any increase in value of the company.

The following is a listing of the most common means adopted by companies to allow key employees to share in the growth and increase in value of the company:

  1. Stock Options: an option gives an employee the right to buy company stock (or an interest) at a later date at the fair market value (“FMV”) as of the date of grant. The option cannot be granted at a price less than FMV at the date of grant. If the company increases in value, the employee can purchase the stock at the grant date value and, therefore, benefit. Before exercising the option the employee may need to satisfy a vesting schedule by remaining employed and/or by the company meeting certain performance targets. There are two types of options: Nonqualified Options and Incentive Stock Options (“ISO”). With a Nonqualified Option, the employee recognizes ordinary income upon exercise and the company receives a corresponding deduction. ISOs only apply to corporate stock and may allow the employee to defer taxation until the employee sells the stock and, if applicable holding requirements have been met, the employee may receive capital gains treatment.
  2. Restricted Stock: corporation grants employee stock subject to a vesting schedule. As the stock vests, employee receives the stock and has ordinary income equal to the FMV of the stock at the time of vesting. Company receives a corresponding deduction at the time of vesting.
  3. Restricted Profits Interest: an LLC taxed as a partnership can grant restricted profits interests to the employee. The great advantage is that if structured properly and certain requirements are met, the employee is neither taxed at the time of grant or vesting. Employee is only taxed once profits are distributed and frequently certain profit hurdles must be met for the employee to receive profit distributions.
  4. Change in Control Payment: this is an arrangement where upon a change in control of the company the employee receives a certain percentage of the net sales proceeds. Typically, the employee must remain employed through the date of a change in control to receive this benefit, but this is not necessary.
  5. Phantom Stock Plan: this is a form of nonqualified deferred compensation. Participants are awarded phantom shares of stock, which while not actual stock, are designed to mirror economically actual stock. Payment can be triggered by the earlier of termination of employment, death, disability, a date certain or change in control. The payment amount is typically based on the increase in value of actual stock from the time of grant to the time of payment.

The foregoing is not intended to be an exhaustive list of key employee compensation alternatives. There are many variations. We would be happy to discuss with you which alternative might be best for your company.

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