An incentive pay structure is a valuable component of the total rewards package that a business can use to retain and motivate its leaders and key employees. These plans tend to focus on long-term incentives that align employee goals to that of the owners — specifically, contributing to the growth of the business.
In this overview, we’ll help you understand the objectives you can achieve using different long-term incentive compensation alternatives as well as the key considerations that go into determining which components are the right choices for your situation. To start the process, we’ve created a chart as a guide that summarizes and compares some of the key incentive compensation alternatives available to employers. Before you review the chart, it’s helpful to consider what you want your executive compensation plan to achieve.
Set objectives for your long-term executive compensation structure
Businesses that want to evaluate their executive compensation strategy typically start by creating a plan that strikes some balance between the following four objectives:
- Attract and retain key executives — Your business doesn’t operate in a vacuum. In a competitive marketplace for top talent, the structure of executive compensation and incentives that you offer will play a critical role in determining whether you’re able to hire and keep the people you want in your leadership positions.
- Incentivize and reward performance — “You get what you pay for.” The old consumer adage also holds true for executive compensation. If you want your business to hit specific targets in areas like growth, sales, and other key measures, your executive compensation structure should include targeted incentives for leaders who succeed in achieving those goals.
- Encourage executives to behave like shareholders — Some businesses reward executives with ownership interests in order to give them a more personal stake in the success or failure of operations. However, there are also nonequity options available to align an executive’s interests with shareholders if the owners want to reward high-performing leaders without diluting their current ownership shares.
- Transfer of ownership — In some cases, the current owners might reach an agreement with executive leadership to transfer ownership of the business over time via ownership interests awarded in exchange for achievement of performance goals.
Answer these questions to determine how you’ll meet your objectives
Once you’ve determined the objectives you want your executive compensation structure to achieve, you’ll need to answer some basic questions about the proposed plan to help you determine what components fit best with your strategy. These include:
- Who’s included in the plan? Which employees do you need to incentivize in order to achieve your objectives? Generally, those in C-suite positions and at senior vice president levels are prime candidates, namely those with a more direct impact on the growth of the business. However, some strategies can include length-of-service awards to employees at lower levels in the business. These can be particularly helpful in sectors with high training costs and steep learning curves, where the business benefits from having skilled workers who have spent years delivering consistently positive results.
- How much compensation is necessary? This is one of the hardest questions for any employer to answer. There are some suggested formulas that can help develop equitable executive compensation packages, but in the end, it always comes down to the specific facts and circumstances of each business.
- When will the awards be paid? The timing of award payments will likely be driven by the objectives that were determined in the first step. If the main goal is an annual supplement to base pay, the compensation package is likely to include one-time or annual grants based on achievement of certain goals. Keep in mind: When planning your executive compensation structure, the more heavily your objective skews toward long-term retention, the more likely it is that the plan will include a vesting schedule over a period of years. And that might mean incremental award payments over an extended time frame, with some payments deferred even as long as retirement or later.
- How do you structure the awards? This is the fundamental question that will drive the remainder of the discussion about a long-term executive compensation plan. Do you want to reward covered employees with incentives that deliver an equity stake in the company or cash payments for performance — or some combination of both?
To better understand the equity and nonequity options you can use to incentivize employees, we’ll look next at a chart that breaks out specific types of equity and nonequity awards and evaluates some of the pros and cons of each. However, before we get into that discussion, you’ll need to understand a little bit about the following two Internal Revenue Code (IRC) sections that can affect the value of certain awards:
- Section 409A determines the point at which some types of deferred income are included in the recipient’s taxable income. In some cases, failure to follow the rules of Section 409A can result in significant additional tax costs (immediate taxation and an additional 20% federal income tax) to employees who receive compensation that isn’t structured properly. It’s a complex area of the tax law, but for our purposes, we’ll simply refer to “409A” when we talk about compensation alternatives that could run afoul of these rules if they aren’t structured properly.
- Section 83 determines the point at which property (i.e., an equity interest) exchanged for services is considered taxable to the recipient. Generally, under Section 83, an individual incurs a tax liability when the property is transferred to the individual. However, if property is transferred subject to restrictions (e.g., vesting requirements), the individual is taxed as the restrictions lapse. Nonetheless, even where property is transferred subject to restrictions, the individual may make an election (referred to as an “83(b) election”) to recognize taxable income at the time the property is transferred, rather than wait for the restrictions to lapse. The decision on whether to make an 83(b) election is based on each individual’s specific facts and circumstances, but generally, the election is prudent where it’s anticipated that the property will increase in value significantly between the time the property is transferred and when the restrictions will lapse. Remember that the types of compensation eligible for an 83(b) election give recipients additional flexibility in determining the timing of inclusion in taxable income.
At this point, it’s time to look more closely at the compensation alternatives explained in our chart. As you review each option, be sure to keep in mind:
- The four objectives for your long-term compensation structure.
- The four questions you need to answer to determine how you’ll meet those objectives.
- The two IRC sections that govern when certain types of compensation will be taxable to the recipients.
What’s best for your business?
Anytime you evaluate the costs and benefits of something as complex as an executive compensation and incentive plan, it always helps to have an experienced, knowledgeable professional guide you through the process. If you have questions about your current compensation structure or are considering potential modifications, reach out to us to discuss your concerns with an employee benefits consultant.
