“Call it what you want, incentives are what get people to work harder.”  — Nikita Kruschev

 

Most of our clients are closely held, often family-owned businesses.  The current owners may be the founders of the business, or they may be a generation or two removed.  Sometimes, the owners have children who are active in the business and who may have manifested an ability to take over the business.  In those cases, our goal is to provide for the smooth transition and succession of management and ownership of the business to those children.

 No Heir?  Or Not Sure Yet?

Quite often, however, the children may have no interest in the business, may not be capable of operating it effectively, or they have not yet exemplified the ability or inclination to do so.

This could put the owners in a quandary, with the only feasible option being a sale of the business at some point down the road.  Of course, the owners’ first priority in this instance will be to maximize the return on their investment, both for themselves and for their family.  Depending upon the business, this may require the retention and cooperation of some key executive employees.

The question, then, is how to incentivize and reward these key employees; how to align their interests with those of the owners; how to entice them to stay with the business, to keep growing the business, to help prepare the business for a likely sale?

There are several options to consider.

 

 Incentive Compensation Choice 1: Equity (or Something Like it)

On the one hand is “equity-based” compensation, which may take two forms.

  1.  Employee becomes an owner.

Under the first form, the employee may become an owner through grants of stock in the employer, bargain sales of employer stock, and non-qualified options to acquire such stock.  In any of these scenarios, the stock may be voting or nonvoting, it may be vested immediately or it may vest over time, and the right to exercise the option may or may not be immediately vested.

  1. Employee Feels Like an Owner

The second form does not involve the actual issuance of employer stock but, rather, seeks to mimic, to some extent, the “economics” of stock ownership.  This includes phantom stock plans (on which there are many variations) and stock appreciation rights. Each of these is basically just a form of non-qualified deferred compensation, the amount of which is tied either to the value of the “shares” credited to the employee’s account or to the appreciation in the value of such shares. (Where the employer is a partnership or LLC, a so-called “profits interest” may be issued, which entitles the employee to a share of future profits and future appreciation.)

The ultimate decision as to which equity-based plan is best suited for a particular business depends upon a number of factors, including the existing owner’s tolerance for minority-interest shareholders, as well as the relative bargaining/negotiating positions of the employer and the key employee.

In my experience, the preference of most business owners is to avoid the actual issuance of equity (even as to family members, at least not until they have proven themselves in the business).  Even with a tightly-drafted shareholders agreement, the rights afforded to a minority shareholder under state common law, and the potential for litigation – especially with an employee with whom there is no familial relationship –  can make issuing equity a risky choice.  Additionally, employees often do not want the obligations that often come along with ownership, e.g., personal guarantees of business loans and leases, restrictions on transfer, etc. (We will cover the issuance of stock options in a future post.  See our post on restricted stock here.)

 

Incentive Compensation Choice 2: Non-Equity Compensation

Alternatively, the incentive may take the form of a deferred compensation arrangement where the amount of the compensation is not tied by some formula to the value of the equity or to the ultimate sale price for the business.  It should be noted, however, that the actual payment of the deferred compensation may be contingent upon the sale of the business.  Indeed, many employers are naturally inclined to defer, and even condition, the payment of the compensation until the occurrence of a major liquidity event. Of course, because the timing of a sale cannot be predicted, such a contingent arrangement may have to account for many factors :

–          Should the executive be immediately vested?

–          Should he or she vest over a number of years, or only upon a sale of the business?

–          Should payments be allowed upon certain events prior to a sale, including at the death or disability of the employee, or for some hardship?

–          Should the deferred compensation be “secured” in some fashion?

Regardless of how these questions are answered, it is important to note that the many ways of structuring a deferred compensation agreement for the key employee of a business all share two critical elements: (A) in order to successfully defer the employee’s tax liability, the arrangement must comply with certain tax principles that have been developed by the IRS and the courts over several decades, and that were modified by § 409A of the Code in 2004; and (B) this compliance must be ensured at the inception of the deferred compensation arrangement – otherwise, the tax and economic results that the parties envisioned will not be attained and someone will be very unhappy.

 

     Nonqualified Plan Basics

It should be noted that, for the most part, these executive compensation arrangements, so-called “nonqualified plans,” are generally not creatures of statute.  Rather, they  are contractual agreements between the employer and the employee, and are very flexible.  They may be structured in whatever form achieves the goals of the parties and vary greatly in design as a result.

Deferred compensation occurs when the payment of compensation is deferred for more than a short period after the compensation is earned (i.e., the time when the services giving rise to the compensation are performed).  Payment is generally deferred until some specified event, such as the individual’s retirement, death, disability, or other termination of service, or until a specified time in the future (e.g., ten years from the inception of the arrangement, or upon the earlier sale of the business).

There are a number of reasons for deferring compensation.  Employers often use deferred compensation arrangements to induce or reward certain behavior; e.g., to retain the services of an employee or to incentivize the employee to attain certain goals (either personal performance goals or operational benchmarks for the business or for the employee’s division).  In the latter situation, the attainment of those goals would trigger either the vesting or payment of the compensation.

Such an arrangement may provide for deferral of base compensation (salary) or incentive compensation (bonuses), or it may provide supplemental compensation (above qualified plan limits).  It may permit the employee to elect whether to defer compensation or to receive it currently.  Alternatively, it may provide for compensation that is only payable on the occurrence of future events. It may be structured as an account for the employee (to which amounts are credited; the benefits payable are based on the amounts in the account, which may even include an actual or “deemed” investment return), or it may provide for fixed benefits to be paid to the employee at some point, or upon some event, in the future.

     The Key Question

The answer to the question of whether or not amounts deferred under a nonqualified deferred compensation arrangement are includible in the gross income of the employee depends on the facts and circumstances of the arrangement.  A variety of tax principles and Code provisions may be relevant in making this determination, including the doctrine of constructive receipt, the economic benefit doctrine, the provisions of Section 83 of the Code (relating to transfers of property in connection with the performance of services), and the provisions of the Section 409A.  Some general rules regarding the taxation of nonqualified deferred compensation result from these provisions.  Usually, the time for inclusion of nonqualified deferred compensation depends on whether the arrangement is unfunded or funded.  If the arrangement is unfunded, as is typically the case, then the compensation is generally includable in the employee’s income when it is actually or constructively received, or when the plan fails to satisfy the requirements of § 409A of the Code.  An arrangement is unfunded if the compensation is payable from general corporate funds that are subject to the claims of the employer’s general creditors,  It is an unfunded and unsecure promise to pay money in the future—the employee has the status of a general unsecured creditor, and his or her rights may not be assigned or encumbered.

     Section 409A

Under Section 409A, all amounts deferred under a nonqualified plan (for all taxable years) are currently includible in the employee’s gross income to the extent they are not subject to a “substantial risk of forfeiture” (i.e., the employee’s rights to the compensation are conditioned upon the performance of substantial services or the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings), unless certain requirements relating to the timing of the distributions are satisfied.

Additionally, almost all incentive compensation arrangements impose certain restrictions upon the employee’s right to distributions.  For example, the plan may include “substantial forfeiture” provisions that impose “a significant limitation or duty which will require a meaningful effort on the part of the employee to fulfill.” Note that whether such a forfeiture provision is effective or not in deferring the employees’ income tax liability depends upon the facts and circumstances of the particular case.  Thus, a provision that is tied to the performance of “consulting services” by a non-employee family member will not be given effect if it is not substantial.

     Rabbi Trust

In order to provide an employee with a sense of security with respect to his or her nonqualified deferred compensation, while still allowing deferral of income inclusion (and tax), a so-called “rabbi trust” may be established by the employer to hold assets from which the nonqualified deferred compensation will be paid.  The trust is generally irrevocable and does not permit the employer to use the assets for purposes other than to provide the deferred compensation, except that the terms of the trust must provide that its assets are subject to the claims of the employer’s creditor in the case of the employer’s insolvency or bankruptcy.  The creation of the trust does not cause the related deferred compensation to be includible in the employee’s income because the trust’s assets remain subject to the claims of the employer’s creditors.  As a result, income inclusion as to the employee occurs as payments are made from the trust, provided these comply with Section 409A.

Thus, an employee will not recognize income under a nonqualified plan until is it paid to him or her (or made available for his or her benefit) in cash or property.  The employer, in turn, is not allowed a deduction for a benefit, contribution or payment until the compensation is taxed to the employee.

Final Thoughts

The foregoing discussion highlighted the basic concepts underlying nonqualified deferred compensation and the basic features of such arrangements. As was noted several times, a family member who is also a key employee of the family-owned business is as likely a candidate for such an arrangement as may be an unrelated employee. The question to be considered is whether it makes sense from a business perspective to reward and retain such an individual. Given the flexibility of such an arrangement, it may be possible to tailor its terms in a way that accounts for the particular circumstances of a family member (e.g., for creditor protection). In the case of a family member-employee, of course, there is also the added benefit of shifting some value to the individual on an income-tax-deductible basis.

What’s Next on the Blog?

This blog post concludes our series on transferring the family business or the value its represents.  Please look for further posts of interest to the closely-held business including, among others, stock options, the sale of the business, buy-sell arrangements, split-dollar life insurance, and others.

If there is a particular topic that you would like to see covered, please let us know.