Hi, my name is Kevin Learned and I am chair of the corporate practice group at General Counsel, PC. Today we are going to be talking about deferred compensation as a means of enticing talented employees to a new business. Really deferred compensation in its most general term is any sort of payment that is not paid currently. Accrued vacation, 401(k) plans, pension plans, those are all deferred comp. What I am going to talk about though is the kind of more interesting versions of deferred comp such as deferred cash payments and equity.

So the first is cash, and cash is still king. The one most common form of deferred compensation is the annual bonus. People don’t often think of it that way, but that’s really what it is. When you have a cash strapped business that doesn’t have cash to pay an employee during the year, and you are also concerned about making sure the employee performs, you can have a cash payment at the end of the year that’s tied to some sort of metric. It’s usually based on a combination of how well the company is doing and how well the employee has contributed to the company and met his own performance metrics.

Similar to the annual bonus, you could have what we call unvested salary. Basically it’s the same thing as an annual bonus, although you have a little more flexibility on when its paid. For example, you bring on an employee in October of one year, and you don’t really want to pay him an annual bonus, but you want to wait, give him nine months, 12 months to kind of really ramp up. And so you might have unvested salary that doesn’t vest until the employee meets his targets.

The other form of deferred salary is what we call a change of control bonus. For example, if the company doesn’t have cash ready to pay out his employees even on an annual basis, but wants to be able to give employees a piece of the business upon a change of control, rather than giving equity, you can simply have a very simple contractual obligation to pay the employee cash at closing. For example, two times their salary, or some set dollar amount based on what you expect that employee’s contributions to be. And that’s a good way of avoiding giving employees an ownership right, but at the same time giving them a piece of the business upon eventual sale.

Other than cash of course, the most common form of deferred compensation is equity, usually in the form of either stock options or restricted stock. Stock options are essentially the right to purchase common stock of the company at a later date, but at today’s current fair market value. Incentive stock options typically vest over time, for example you bring an employee on, you don’t want to give him a piece of the company right away, so you might have the stock not vest even in part until maybe the employee’s been there for about a year. So for example, you may have one-fifth to one-third of the stock vests after a year, and the remaining stocks vests either annually thereafter or maybe even on a monthly basis once the employee has proven that he’s valuable to the company.

There is some restrictions on incentive stock options. For example, the maximum amount that can be vested in one year is $100,000. And also more importantly, the stock must be valued at fair market value at the time of grant. And this is probably one of the biggest stumbling blocks new companies have, is determining what that fair market value is. The IRS has very stringent regulations on how fair market value is determined. It can’t just be a number you pick out of the air. Typically, you either have to have a current arms length transaction, for example you have an outside investor who buys stock in the company and pays X dollars per share. That’s a valuation you can use. Or absent a third party transaction, you have to actually go out and get a third party valuation firm that meets IRS guidelines to do those valuations. Unfortunately those can be kind of pricey, usually in about the $7-10,000 range, which seems like a big nut to swallow for small companies, but it really is necessary. There’s very strict guidelines. If you don’t issue at fair market value, there’s some very negative tax consequences that can come out of that.

The benefit to incentive stock options for employees is that they’re not taxable when received. In fact they’re not taxable when they’re exercised. They’re only taxed when in fact there’s a cash payment that comes out. Now those are usually taxed at ordinary rates unless the employee has exercised the options and held them for both a year and the transaction happens at least two years after grant date. In practice though, employees tend to not exercise stock options until it’s pretty clear that a transaction’s going to happen, or in fact they don’t exercise them at all and the exercise happens in connection with the transaction itself.

The other form of equity is restricted stock. In this case they’re very similar to options. However unlike an exercise price, this is stock that’s actually purchased by the employee. This is a good tool to use when the company is brand new and has a very very low valuation, either because it’s really just a bunch of ideas, it really hasn’t gotten off the ground yet, or if the company has incurred a lot of debt and so even though it might have some valuable assets, the liabilities overcome those and so you have a very low valuation. What this allows is, you allow employees to own the stock from day one, therefore as long as there’s a transaction at least a year down the road, they get the capital gains treatment. So restricted stock is good in that respect.

Now there are a couple of options that are kind of in between equity and cash. These are stock appreciation rights and phantom stock plans. These are plans where instead of actual stock options or ownership in the company being issued, the employee is given what is often called “units” that closely track the valuation of the stock. And again, instead of having an exercise price, they’re kind of pegged at the starting value, and the employee gets the difference between the starting value of the stock and what the value is at exercise. These are a little bit different than stock options though, in that when they become vested, the employee actually has the right to get paid out cash or stock if that’s the payment metric for the stock option rights, stock appreciation rights or the phantom stock plan. However you can avoid this by, instead of having time vesting, you can do it again based on a trigger such as vesting upon a change of control event. And so plans like stock option appreciation rights or phantom stock plans are kind of a good middle ground between cash and equity.

Now of course things aren’t always as easy as they seem. There’s of course a number of IRS regulations that apply to deferred compensation arrangements. The most important being 409A, which are relatively new regulations that restrict the ability of companies to defer payment to later periods for compensation that’s earned currently. The main way to avoid situations like this is to not have a plan that allows employees to vest or obtain a legally binding right to receive payment in one year and then pay it later. And the best way to do that of course is to have these payments not vested and have them tied to either timing restrictions or often more likely to performance based triggers.

The negative impact of the IRS regulations are pretty significant. For one, there’s usually a 20% excise tax plus interest on these payments. And also importantly to companies, the company can lose the full tax deduction of those payments made to the employees. There’s some exceptions to these rules, statutory stock options are one of them, which we talked about previously. But whenever you’re dealing with a deferred compensation arrangement, you definitely need to engage competent corporate counsel to help work through those issues.

Another significant IRS regulation to be concerned about is 280G, which deals with excess parachute payments. What parachute payments are is payments to employees in excess of three times their base amount. Base amount being defined as the employee’s base salary plus bonuses and all compensation generally received over the previous five years. The excess parachute payment is those payments in excess of 1x of that base amount. So for example, you have an employee who makes $100,000 a year. You pay him a bonus of $400,000 upon a change of control. That’s more than three times their base. The excess amount is $300,000 (400 minus 100). And that’s the excess base amount. Those parachute payments are subject to significant penalties under IRS regulations. Again it’s the same thing, it’s the 20% excise tax plus interest, loss of corporate deductions. There are some exceptions to those. For example, if those payments are limited to or subject to forfeiture upon a vote of the stockholders that’s less than 75%. And there’s some other restrictions as well.

In addition, it’s not just the cash payments. For example, accelerated vesting of your stock options can also trigger 280G. So for example if you’ve got stock that normally is only vested one year and you accelerate a year or two of vesting, that adds another couple hundred thousand dollars of payment to an employee. That also gets built into the calculation of what is an excess parachute payment. Again, these are not easy regulations to walk yourself through, like with 409A, something you really need to talk to corporate counsel and benefits counsel with as well. And of course there are a number of other IRS regulations that pop up as well.

So, that’s been a brief primer on deferred compensation for employees. I hope you found it useful and not too much information to swallow in one bit. Again, my name is Kevin Learned, and I am the chair of General Counsel’s corporate practice group. If you’d like to contact me directly, please feel free to do so at klearned@generalcounsellaw.com. Thank you.

Thanks for listening to this edition of the Legal River podcast. If you have a business law question you would like to see answered in a podcast, please email us at Podcast@LegalRiver.com. To reiterate, all views expressed in this presentation are intended only as a general discussion of the issues and should not be regarded as legal advice. For additional details or advice about a specific situation, please consult legal counsel directly.