Different types of employee compensation
There are many types of employee compensation for staff of a company.
When you hear the word “compensation,” the first thing that you might think of is getting that extra money in your paycheck. While this may feel great in the short term, and even though cash is one of the various forms of employee compensation options out there, it is not the only type. There are many types of employee compensation for staff of a company.
Being the owner of the company, it is vital to know about a complete employee compensation package and what types you can include. This is so you can explore the best options for incentivising your staff to grow the company.
Having the right knowledge about this can also help you with any doubts you may have regarding compensation and market competitiveness. This article helps you with just that, letting you know about the various types of employee compensation, namely the ones related to stock options.
Before we can move ahead with the types of employee compensation, let us first understand what employee compensation means. It refers to the benefits provided to an employee in exchange for their services for the business. As a matter of fact, employee compensation is normally one of the highest expenses in a company.
In the United States, about 92% of the working population is made of employees that earn compensation from their employer. Here the compensation is not just salary or bonuses, there is much more to it. And with the most common being equity in the US, we would be talking about equity compensation in this article.
What are the different types of employee compensation?
When talking about the different types of equity compensation available, there are many under this. Each equity-based program has some special considerations both in terms and price.
Below explains all the types of equity-based compensation in detail, so that you can choose the best type of employee compensation for your business:
Before we can talk about this type of employee compensation, let us understand a few terms that are used to define stock options and how they work:
- Vesting: Vesting means to earn the rights to a future payment, asset or benefit after a defined time period or within a time period.
- Option term: The time limit when the employee can hold the option before it expires.
- Spread: The difference between the exercise price and the market value of the stock at the time of exercise.
- Exercise: When a stock option has been purchased.
- Exercise price: The stock’s price at which it can be bought. The price of the stock is normally based on the fair market value of a similar stock when granted.
Under a stock option, which is one of the types of employee compensation, an employee of a company gets the option to purchase a predetermined number of shares of the company at a set price. The stock options vest over a period of time or as soon as a group, corporate or individual goals are met.
A few companies usually set schedules for vesting, which means that the person can exercise the stock option only after they have vested. But these companies also allow the options to be vested sooner in case the performance goals are met beforehand. as soon as the options are vested, the employee has the option to exercise it at the grant price within the given term, before the expiration date.
Let us take an example to understand this. An employee of a company has the rights to purchase 1,000 shares of the company at $10 per share. The options vest 25% per year over a 4-year period and have a time period of 10 years. In case the stock increases, the cost per share for the employee would be $10 per share.
The difference between the $10 grant price and the exercise price is the spread. For instance, if the stock reaches $20 after six years and the employee exercises all the options, the spread would be $10 per share.
Options (ISO, NSO, NQSO)
Options are normally of two types namely; nonqualified stock options (NSOs) and incentive stock options (ISOs). The NSOs are also called “nonstatutory stock options” at times. As soon as an employee exercises a NSO, the spread of the stock after the exercise is taxable to the employee as income. This is the same even if the shares have not been sold yet.
The corporation deducts a similar amount. Even though the company can impose a holding period on the shares after they have been exercised, there is no legally required period. Any following gain or loss of the shares when it is exercised is taxed as capital gains as soon as the optionee sells the shares.
Unlike the other types of employee compensation, an ISO allows the employee to:
- Pay taxes on their complete gain at capital gain rates instead of paying them on the ordinary income tax rates
- Delay taxation on the option after it is exercised until the date when the underlying shares are sold
For this too, some specific conditions are met for being eligible for ISO treatment:
- The stock must be held by the employee for 1-year from the exercise date and for 2-years from the grant date.
- The option has to be exercised within ten years of the date of grant.
- Only employees can qualify for ISOs.
- During the grant, in case the employee has more than 10% of the voting power for the outstanding stock of the business, the exercise price of the ISO has to be at least 110% of the fair market value of the stock at that time. Moreover, it might not have a term that is more than 5 years.
- Unlike the other types of employee compensation, under this, the option has to be issued according to the written plan by shareholders. This would define how many shares can be granted and the type of employees to get the options. The options have to be issued within a 10-year period of the adoption date of the board of directors.
- The exercise price should not be less than the fair market price of the stock during the issuing period.
- During the first calendar year and in one year, only $100,000 of stock options can be exercised, which is measured by the fair market value of the options during the issuing date. In case there is vesting that is overlapping, the company has to track the outstanding ISOs to make sure that the total that gets vested, under various issuing periods, should not exceed $100,000 in value during a year. If there is any part that exceeds the limit, it is treated as an NSO.
In case all the above are met, the sale of the share would be called a “qualifying disposition.” The employee would pay the capitals gain tax on the increase in value between the grant price and sale price. Moreover, there isn’t any tax deduction taken by the company in this case, for the ISOs as one of the types of employee compensation.
But if there is a “disqualifying disposition,” which happens when the employee exercises and sells the shares before the holding periods, the exercise spread is taxable at ordinary income tax rates for the employee. Also, the decrease or even increase in the value of shares between the sale and exercise would be taxed at capital gains rates. For this, the company might subtract the spread on exercise.
If the employee exercises the ISOs and doesn’t sell the underlying shares in that year the spread on the option is a “preference item” for the AMT (alternative minimum tax). So, it does not matter if the shares have not been sold, the exercise needs the worker to combine back the exercise gain and the other AMT preference details, to understand if a different minimum tax payment is due.
On the other hand, the NSOs can be granted to anyone in the company where there is no particular tax for the NSOs. But just like the ISO, no tax is present on the option’s issuance, and when it is exercised, the spread is taxable as ordinary income. Moreover, the corporation gets a similar tax deduction.
Note: In case the price of the NSO during exercising is less than the market price, it is subjected to the partial compensation laws according to Section 409A of the Internal Revenue Code. Moreover, it might be taxed at vesting and the option recipient can be subjected to penalties.
Not sure how an option is exercised? The next part explains it.
Exercising an Option
You would be come across exercising options in many places as we talk about the types of employee compensation here. There are many methods to exercise an option, and these are:
- By purchasing them with cash
- By working with a stockbroker for making the sale on the same day
- By exchanging the shares that the optionee already owns (known as stock swap)
- By completing a sell-to-cover transaction
The next type of equity benefits under the types of employee compensation is restricted stock plans, where the employee is allowed to buy the shares at fair market value or at a discount. There are also cases where the employees can receive the shares at no cost. Nevertheless, the shares they get are not really theirs, until the specified restrictions lapse.
Normally, the vesting limitations end when the employee works in that company for a specified number of years (such as 3 to 5 years). The time-based restrictions end gradually or all at once. However, any restriction can be imposed by the company, where the employee can vest the shares if the individual, corporate, or departmental goals are met.
Unlike other types of employee compensation, with the restricted stock as a benefit, the corporation can select if they want to pay dividends, grant the employee voting rights or other advantages of being a shareholder before the vesting period.
For this benefit, the employees have the rights to make the “Section 83(b)” election. Under this, they would be taxed on the “bargain element” of the benefit during the grant at ordinary income tax rates. In case the shares are just given to the employee, the bargain element is their full value.
In case a fee is paid, the tax would be on the difference between the paid fee and market value at the time of the grant. If the complete amount is paid, there is no tax. For any future changes in the share value between the sale and filing is taxed as the capital loss or gain, and not ordinary income. The person who does not make the 83(b) election, has to pay the ordinary income taxes on the difference of the paid amount and the fair market value of the shares, as soon as the restrictions end.
The company gets tax deductions only when the employee pays income tax on the amount, regardless of Section 83(b) election. As a matter of fact the Section 83(b) election comes with some risks. If the employee makes the election and pays the taxes, but the limitations never end, the employee would not have the taxes refunded nor would they get the shares. To understand this more, you may need to consult your lawyer or tax advisor.
Restricted stock units (RSUs)
This is another types of employee compensation which differs from restricted stocks, as mentioned above. RSUs, restricted stock units, are granted to employees via a distribution schedule and vesting plan after the employee stays for a long time in the company or achieves performance milestones.
The RSUs give the employee an interest in the stock of the corporation, but there is no tangible value until the vesting is completed, and when they vest, they are given as per the fair market value. When they are vested, they are regarded as the income of the employee and a part of the shares are withheld for paying income taxes. The rest of the shares are given to the employee and they can sell it as per their choice.
It is important to keep in mind that unlike restricted stocks, RSUs are not eligible for the Section 83(b) Election. RSUs do give voting rights, and do not provide dividends since they are not allocated. However, the owner can pay equivalent dividends that would be withheld for income taxes. In case an employee leaves the company before the vesting schedule ends, they abandon the remaining shares of the corporation.
Stock Appreciation Rights (SARs)
Another types of employee compensation that is given under equity compensation is SARs, which is “stock appreciation rights”. It is like a bonus for the employee which is equivalent to the appreciation of company stock over an established period.
SARs are profitable to the employee the moment the stock prices of the company rises. And in this case, the employees would not have to pay the exercise price here. Instead, they get the sum of the rise in cash or stock. Moreover, the employee can obtain profits from stock price rises without being obligated to purchase anything.
Phantom Stocks are another type of employee compensation, where employees get the benefits of stock ownership without actually getting the stock of the company. This is why it is also called shadow stock. Even though they do not hold the actual stock, it follows the same price movements and pays the employees the resulting gains.
This means that after some time, the cash value of the phantom stock is given to the employees participating in it. As a matter of fact, the phantom stock has no restrictions or requirements for using it. In short, the phantom stock can also be altered at the discretion of the leadership. Many organization use this type of compensation for their upper management employees.
Phantom stock even offers companies with some restrictions when providing incentives tied to stock value. This is mostly for limited liability corporations (LLC), S-companies or a sole proprietor that are restricted by the 100-owner rule.
There is a phantom stock appreciation right, which is a stock-based program where it functions as a part of a retirement plan for the employees. It grants raised incentives while the value of the company rises. This plan retains the employees and gives them security.
Since phantom stock is one of the types of employee compensation plans, it has to meet the requirements of the IRS code 409(a). The program has to be accurately vetted by a lawyer, with all of the relevant information defined in writing.
SARs and Phantom Stock
The phantom stocks and SARs are largely similar. The one main difference is that phantom stocks is a false stock that assures the employee that they would get incentives equivalent to the value of the shares of the company as per the current fair market value. Moreover, the bonus the employee gets is taxed as ordinary income.
On the other hand, SARs provide the right to the cash equivalent of value gains of a specific amount of stocks over a period of time. This is typically paid in cash, however the organization might pay it in shares as well. In many cases, the SARs can be exercised as soon as they are vested (since they become available to exercise).
The SARs are usually granted in connection with stock options to help pay off taxes due at the time the SARs are exercised or in financing the acquisition of options; these are known as “tandem SARs.”
Employee Stock Purchase Plans (ESPPs, ESOPs)
There are two types of employee stock plans, but first, we would talk about the ESPP, which is the employee stock purchase plan. It is a company-run program where the employees that wish to participate can join in and purchase the shares of the company at a discounted price.
Employees provide to the scheme by allowing payroll deductions, which grows into a large amount between the date of the offering and the purchase day. And when the purchase day comes, the corporation uses the gathered amount to buy shares of the business on behalf of the employees.
Under this plan, the discount rates on the shares of the company are based on the particular program. But these rates can be as low as 15% of the actual market price of the shares. This discount is taxed as ordinary income, while the remaining amount gained is taxed as long-term capital gains.
ESPPs might have a “look back” requirement permitting the program to utilize a traditional closing rate of the shares. This cost might be the price of the stock purchase date or offering date. In short, the one that is lower is always considered.
In the application process, the employees let the company know how much they want to be deducted from their pay, to contribute to the plan. There might be a limitation on the percentage of the deduction that can be made. Additionally, the IRS limits the total dollar amount contributed to $25,000 in a year.
Qualified Vs. Non-qualified Plans
ESPPs include two types: non-qualified and qualified. The qualified plans need the permission of the shareholders of the company before it can be implemented. Moreover, the plan participants would have the same rights in the plan. There are limitations on the maximum discount price that is allowed in this plan and the offering period of a qualified ESPP is never greater than three years.
The non-qualified plans are usually not subjected to any limitations like qualified ones. Nevertheless, this plan does not have any tax advantages like the qualified plan has. As a matter of fact, the unqualified dispositions can have the entire gain taxed at ordinary income taxation rates.
As per the ESPPs, anyone in the company who already has 5% of the company stocks is not allowed to participate in the plan. Employees that have not worked with the company for a specific time are not allowed to participate either. This time period is about one year normally. The rest of the employees usually have the choice but are not obligated to take part in the plan.
Employee Stock Ownership Plan – ESOP
The next type is the employee stock ownership plan, which is one of the types of employee compensation that is a qualified defined-contribution employee compensation plan created to fund principally in the sponsoring stock of the employer. The basic meaning of “ESOPs being qualified” is that the ESOP’s sponsoring corporation, the participants, and the selling shareholders get multiple tax benefits.
The corporations usually use the ESOPs as a corporate-finance plan and for aligning the interests of their employees and shareholders. As a matter of fact, the companies usually utilize ESOPs to have all the participants in the plan focused on the share price appreciation and the corporate performance. The employees take things seriously since the ESOP shares are given as a part of their compensation for the work they offer the company.
Due to the interest of the participants, their ideas become the same as the shareholders and they work towards making it come true. The corporations offer the employees with such kind of ownership with mostly no upfront costs, although the company might hold the shares in a trust for growth and safety until the worker resigns or retires from the company.
Companies usually join distributions from the plan to vesting (the proportion of the stock that the employee got for each service year) and when the employee leaves the corporation. As soon as the shares are vested completely, the company purchases the shares back from the resigning or retiring employee. This amount then is given to the employee in equal periodic payments or a lump sum or, depending on the plan.
After the company buys the shares back and pays the employee, the shares are redistributed or the stocks are voided. The employees that leave the company cannot take the shares but get the money. Fired employees only get the amount they have vested in the plan.
The corporations that have this plan is an employee-owned corporation where the majority of holdings are by their own employees. These organizers are like groups, just that the organization doesn’t share its capital equally. There are many companies that only offer the rights to vote to specific shareholders. Businesses might also offer the senior employees with more shares as a benefit over those new employees.
Which ones are the best for your company?
Even though all the stock options have their pros and cons, it all depends on how you believe in your company and it growth. As a matter of fact, in case a company does not wish to conduct an independent valuation for awarding compensation, it could consider offering restricted stocks to the employees. This is an advantage it has over granting stock options (which requires a company valuation); however, it would still need to have accurate reporting of this for tax purposes.
Now that you know all about the various types of employee compensation, you might have doubts about which one is best the different types of company. The next article would give you a much better idea about choosing the best option for your company. Check out the details!