Human Capital & Careers

Taxing Problem in Long-term Compensation

Executives who determine a company's pay structure may find themselves weighing the merits of two compelling priorities: securing short-term tax be...
Lisa YoonFebruary 24, 2006

When the Financial Accounting Standards Board tackled options expensing by introducing FAS 123R, accounting concerns were on the top of the agenda for many companies. But tax implications play a part, too.

CFOs and other executives who determine a company’s pay structure may, in fact, find themselves weighing the merits of two compelling priorities: securing short-term tax benefits and securing long-term employees.

Companies that offer non-qualified stock options are able to take a tax deduction on the exercise date; the recipient’s proceeds are taxed as ordinary income. On the other hand, companies that offer incentive, or qualified, stock options — the kind used in most compensation plans — forgo a tax benefit now so the recipient of the options will be taxed only later, upon sale of the stock. Provided the sale date is at least two years after the exercise date, the recipient pays capital gains and takes less of a tax hit.

At first it may seem an easy choice: What company wouldn’t want a tax benefit for itself? It’s easily measurable, and it boosts earnings — in the near term, no less.

The incentive for the company, of course, is offering an incentive that helps it to hire and retain employees. “From a compensation director’s standpoint, it’s easy to grasp the benefits of [incentive stock options] on company performance,” says Derrick Neuhauser, a senior manager at accountancy BDO Seidman.

Companies that offer restricted stock as part of their compensation package also can partake of a tax benefit. The employer takes a deduction based on the stock’s fair value at the vesting date; employees receive a grant of shares with no out-of-pocket costs. But unlike stock options, which can be exercised only if the share price hits a certain target level (the “strike price”), restricted stock is typically granted outright on a certain date.

The criticism, then, is that although the company has offered an incentive to employees while receiving a tax break itself, the company is also “paying for pulse” without holding employees properly accountable. (Perhaps Woody Allen had this in mind when he observed that “90 percent of life is just showing up.”) Increasingly, restricted-stock programs incorporate performance criteria on which the stock grants are contingent.

Neuhauser believes that “pay for performance” will compel companies to become more creative in designing their compensation plans. Before FAS 123R, he observes, stock options often were the default for long-term compensation, precisely because they didn’t hit the balance sheet. Now, he adds, “companies have to think about aligning awards with corporate performance more than ever.”

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