EXECUTIVE COMPENSATION PLANS

In a salary reduction arrangement, the employee agrees to give up a specified portion of current compensation (salary, raise, or bonus). In turn, the employer promises to pay a benefit in the future that is equal to the deferred amounts plus a predetermined rate of interest. This feature is similar to a 401(k) salary deferral plan because both plans permit an employee to defer the receipt of compensation.

A salary reduction arrangement is sometimes called an “in lieu of” plan because the employee is receiving the employer’s promise to pay benefits in lieu of current income. Literally speaking, it is a pure deferred compensation plan.

A popular form of nonqualified plan is the excess benefit plan. It may be established for any employee; however, an excess benefit plan is typically used to benefit highly compensated employees. This plan continues where qualified plans leave off, due to Section 415 limiting qualified plan contributions. This plan is defined as a nonqualified plan that provides for benefits that restore those benefits lost due to the operation of Section 415 concerning qualified plans. These excess benefits are determined by the same formula found in the qualified plan. So, the excess benefit plan only provides for contributions or benefits beyond the Section 415 limits as determined by the formula of the qualified plan.

The payment is typically made upon an employee’s retirement and is usually paid in the same manner that benefits are paid under a qualified retirement plan. The plan may be either “funded” (i.e., specific property is set aside to secure the obligation accruing to the employee and this property is not subject to the company’s creditors) or “unfunded” (i.e., a mere promise is made and there is the risk of nonpayment of the benefit due to a change in company policy or to a change in financial capacity).

For a nonqualified plan to qualify as an excess benefit plan, its purpose must be limited to restoring benefits or contributions provided by a qualified plan, but lost by a plan participant due to the limits of Section 415.

A supplemental executive retirement plan (SERP) is a funded or an unfunded plan providing benefits for select employees in excess of those provided by the employer’s qualified retirement plan. Although SERPs are similar to excess benefit plans, they do differ.

While excess benefit plans technically can cover any employee, SERPs generally are provided only for high-level executives. The payments made are generally offset with payments arising out of the company’s qualified retirement plan obligations. The purpose of a SERP is to provide adequate postretirement income; thus, it generally bases its benefit on elements of compensation not otherwise provided under the qualified plan, such as by using a benefit formula with a higher multiple of earnings or by ignoring altogether the integration level or levels sometimes existing in qualified plans. SERPs often provide disability retirement benefits computed on some basis consistent with that of the normal or early retirement benefit provided under the company’s qualified plan. Finally, SERPs are used to make early retirement more attractive. SERPs are generally unfunded and generally subject to ERISA unless they are sufficiently limited in scope to be considered a top hat plan.

A “top hat” plan is a type of unfunded SERP that provides benefits to a select group of highly compensated individuals. Even though a top hat plan is unfunded, it is nevertheless subject to the reporting and disclosure requirements of ERISA, although not to other provisions. The reporting and disclosure requirements generally are not onerous, however. For unfunded or insured deferred compensation plans for executives, these requirements can usually be satisfied by a single filing of a brief informational statement with the Labor Department and by providing plan documents to the Labor Department if they are requested.

Employer-sponsored irrevocable trusts used by unfunded plans are more commonly referred to as “rabbi trusts.” The first irrevocable trust approved in this scenario was sponsored by a synagogue for its rabbi, hence the name. A rabbi trust is a form of irrevocable grantor trust that is established by an employer.

Contributions are made to the trust, and accumulations are subsequently used to pay out the deferred compensation to the key employee. As per the definition of a grantor trust, the trust earnings are currently taxable to the grantor, or employer, rather than imposed upon the employee. As grantor and owner of the trust assets, the employer may use these assets only to satisfy the obligation owed the executive. The exception to this rule occurs when the employer becomes bankrupt or declares insolvency. In that case, the trust assets must be available to satisfy the general obligations of the employer’s creditors. Thus, the earnings on investments used to fund the trust are not currently taxable income to the executive. Life insurance is frequently used in a rabbi trust, and sometimes employer stock or mutual funds are used as well.

A secular trust is an irrevocable trust established for the purpose of providing nonqualified plan benefits to an employee. Secular trusts may be employer-funded or employee-funded. An employee-funded secular trust is a type of grantor trust that is established by an employee. (Income earned by a grantor trust is taxed to the grantor, the employee in this situation.)

Unlike assets in a rabbi trust, employee-funded secular trust assets are not subject to the claims of an employer’s creditors. The secular trust is designed to be the opposite of the rabbi trust. The plan will not include a substantial risk of forfeiture provision, and the employee will be in constructive receipt of contributions made to the trust.

If properly structured, an employee-funded secular trust consists of a fully funded arrangement on behalf of a named employee. Typically, assets in the trust are invested in tax-deferred assets such as permanent life insurance, tax-exempt securities, or other similar investments. Therefore, the increase in value of the tax-deferred assets usually will not be taxable to the employee-beneficiary until payments are made from the trust.

Death-benefit-only plans are just what the name implies: The only benefit they provide is a death benefit to the employee’s designated beneficiary. A death-benefit-only plan (DBO plan) is a type of ERISA welfare plan often misclassified as a nonqualified deferred compensation plan. (A welfare plan is an employer-sponsored plan that provides, among other things, death, disability, sickness, accident, or unemployment benefits for its participants (see ERISA Section 3(1)). A DBO plan is not considered to be an ERISA employee pension benefit plan because it does not provide retirement benefits, nor does it provide for the deferral of income. Welfare plans are subject to ERISA’s reporting, disclosure, fiduciary, administration, and enforcement requirements; however, they are not subject to ERISA’s participation, vesting, and funding requirements.

A death-benefit-only plan is a valuable tax planning tool for a highly compensated employee who has a large estate that may be subject to significant federal estate taxes, even after the unified credit and marital deduction are taken into account. It’s valuable because a properly designed death-benefit-only plan is excluded from federal estate tax for a highly compensated employee who owns 50% or less of a closely held corporation’s (i.e., the employer’s) stock. All payments are taxed as ordinary income to the beneficiary.

These may be Performance Unit or Share Plans, Phantom Stock Plans or other equity-based compensation arrangements such as below.

There are basically two major categories of equity-based compensation plans. The first category involves the actual, current transfer of corporate stock to the employee-participant. The other grants an employee the right or option to purchase employer stock at some future date or measures his remuneration at some future date based on the performance of the employer’s stock. Within these two categories are several types of plans. The most important equity-based compensation plans are incentive stock options (ISOs) and nonqualified stock options (NSOs). See below.

Under the Company’s directors’ fees deferral plan, a director may elect to defer receipt of his or her fees to future years and to receive interest thereon, compounded quarterly, at the prime commercial lending rate of JPMorgan Chase, as of the end of the previous calendar quarter. Distributions from a director’s account, which may be made before or after a director ceases to be a member of the Board, generally will be made in a single lump sum distribution; however, a director may elect, in accordance with the deferral plan, to receive a distribution in up to 10 equal annual installments.

Companies offer Employee Stock Purchase Plans to employees to allow them the opportunity to share the success of the firm. A stock purchase plan enables employees to purchase their company's common stock, often at a discount from the market price.

Stock options are perceived to be an effective employee retention and incentive tool. Stock purchase plans help employees think more like an owner, which aligns their interests with those of shareholders.

Under a typical Stock Purchase Plan, employees are given an option to purchase their employer's stock generally at a discounted price at the end of an offering period. Prior to each offering period, eligible employees indicate if they wish to participate in the plan.

If the employee wishes to participate, he/she indicates the percentage or dollar amount of compensation to be deducted from their payroll throughout the offering period. The percentage or dollar amount employees are allowed to contribute varies by plan, however, the IRS limits the total purchase to $25,000 annually.

There are two types of Employee Stock Purchase Plans, classified by their tax status:

Qualified Employee Stock Purchase Plans (Section 423) and Non-Qualified Employee Stock Purchase Plans.

Nonqualified stock options (NSOs) are legal agreements (contracts) giving employees (typically executives) the right to buy the company’s common stock at a particular exercise price or strike price at a particular time or during a particular period after the options become vested.

Because the option is nonstatutory, there are very few legal requirements other than those resulting from state law and securities law. For example, the price may be equal to fair market value at the date of grant or substantially below the value at the date of grant. There is no holding period requirement, although some plans require one. As a general rule, nonqualified options are nontransferable and the value of the option itself at the date of grant is not readily ascertainable; therefore, they are not subject to tax until they become vested at some point in the future. Hence, they are not taxable when granted under the cash equivalency or economic benefit rules.

There is no holding period requirement, although most plans generally require one. Finally, nonqualified stock options typically are made nontransferable so that the cash equivalent or economic benefit rules do not apply.

Incentive stock options (ISOs) are legal agreements (contracts) giving employees (typically executives) the right to buy the company’s common stock at a particular exercise price or strike price at a particular time or during a particular period after the options become vested. By law, the exercise or strike price for ISOs must be not less than the current market price for the stock.

Incentive stock options are used by various publicly held corporations. Some smaller companies strapped for cash use them as an alternative form of compensation. The underlying stock in such an arrangement is frequently common stock, but it may be any capital stock, including nonvoting common stock and preferred stock. At the time of the grant of the option, it is anticipated that the executive will be able to purchase the underlying stock at a “bargain price.” Therefore, incentive stock options are similar in certain respects to nonqualified plans and are usually maintained by a corporation for a select group of management or highly compensated employees. Such options are not subject to the provisions of ERISA but the excercising of ISOs is a preference item for AMT (Alternative Minimum Tax) purposes, so prudent exercising of ISOs must be considered.

Section 83 plans are nonqualified plans in which an employer transfers property that is subject to forfeiture to an employee (typically an executive or independent contractor) in exchange for the performance of services. Three of the most popular types of Section 83 plans are

• Nonqualified stock options,

• Stock appreciation rights (SARs), and

• Restricted stock plans.
  
  

A stock appreciation right (SAR) is nothing more than an imaginary unit somehow compared to the value of the common stock of an employer. Generally, SARs are based on the fair market value of employer stock. However, a formula price also may be used to determine the unit value of a SAR. Obviously, a formula price makes more sense in a closely held business than in one where the stock value is readily identifiable by a market or stock exchange. The amount of compensation paid to an employee (and the amount of taxable income recognized by an employee) is measured by the performance of the employer’s stock. As the stock increases in value, the SAR increases in value. As the stock decreases in value, the SAR decreases in value, but not below the value or formula price at the date of grant of the SAR.

The grant of stock options, either statutory or nonstatutory, is frequently accompanied by SARs. A SAR plan may authorize the employee to be paid in stock instead of cash, or both stock and cash, and may even allow the employee to choose between stock and cash or a combination of the two. When a SAR plan is combined with a stock option plan, the SAR plan generally provides that SARs may be exercised only to the extent of a certain number of shares of company stock subject to the option. A SAR granted in connection with an incentive stock option is subject to the statutory rules governing incentive stock options.

Restricted stock refers to stock that the employer uses to compensate executives, but which contains some restriction or limitation preventing the executive from having all the rights and responsibilities available to an owner of unrestricted stock. These restrictions are used to promote a beneficial result to the company. For example, a plan may restrict the sale of stock by the employee until he or she has remained with the company for a specified number of years after issuance of the stock. Restricted stock used in a deferred compensation arrangement is usually stock of the employer company, but it may be stock of another company. The use of stock of another company will result in taxable gain or loss to the employer when it is transferred to the executive. Use of the company’s own stock will not result in a taxable transfer and may provide the executive with a greater incentive to accomplish his or her employer’s goals.