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Long-Term Incentive Plans for ESOP Companies

An NCEO Issue Brief

by Paul Horn and Matt Keene

This is one of our archived publications; specialized publications that have been removed from our main publication list and are not being updated, but are are still available for purchase, although sometimes only in digital form.

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Long-term incentive plans ranging from cash incentives to equity compensation play a vital role in many ESOP companies, serving several purposes. This detailed issue brief begins by addressing basic concepts such as employee coverage, taxation, accounting, governance issues, S corporation issues, and so on. It then discusses financing (including sinking funds, COLI, and rabbi trusts). The authors then discuss the various types of plans available, including non-equity incentives (cash incentives, SERPs, etc.), equity plans (stock options and restricted stock), and equity-based plans (phantom stock and SARs), noting which plans are more likely to be used in the ESOP context and why.

Publication Details

Format: PDF, 26 pages
Dimensions: 8.5 x 11 inches
Edition: 1st (September 2012)
Status: Available for electronic delivery

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Contents

Introduction

Basic LTIP Concepts
Employee Coverage
Taxation of Benefits
Accounting Treatment
Equity Dilution
Governance
Special Considerations for S Corporations
Liquidity and Award Duration

Financing the Award Obligation
Sinking Funds
COLI
Rabbi Trusts

Non-Equity Incentive Plans
Deferred Cash Compensation
Excess Plans
SERPs
Long-Term Cash Incentive Plans

Equity Plans
ISOs
NSOs
Restricted Stock

Equity-Based Plans
Phantom Stock
Stock Appreciation Rights (SARs)

Conclusion

Excerpts

Unlike public company shares, no similar market exists for private company stock. While the private company could have a liquidity event via an IPO or sale to a third party, these events are far from certain and their timing unknown. Thus, the private company must have a repurchase program to provide real liquidity for both actual equity and equity-based awards issued under the LTIP.

This repurchase issue can become a problem for LTIP participants where they are taxed, for example, on the full amount of their option exercise and sale to the company, but the company can pay them only in part because of an annual liquidity limit or other cash flow constraints. Actual equity awards, such as restricted stock and stock options, can present a timing mismatch because the awards are generally taxed to the recipient when vested or exercised, even if the company does not have the cash to monetize the settlement of the award.

Due to these liquidity constraints and the other issues we have already discussed, most LTIPs for privately held ESOP companies are in the form of equity-based awards. The equity-based awards—namely phantom stock and SARS—are normally settled in cash, and the recipient's taxation generally matches the receipt of cash.

The "cost" of this liquidity can be significant, and this LTIP liability is in addition to the ESOP repurchase obligation. On this note, when an executive covered under both an ESOP and LTIP separates from service, it creates a true "repurchase obligation" under the ESOP because the company is required to purchase the ESOP shares. Technically the obligation to monetize the equity-based LTIP award is not a true "repurchase obligation" since there are no shares to be purchased, but we will use the term repurchase obligation generically to refer to the company's total cash outlay needed to settle both the ESOP and LTIP liabilities.