Today I have a grab bag of short topics for you, each worth mentioning but none are really long enough for their own blog.
The Most Ridiculous Section 162(m) Lawsuit Ever Last year, a Delaware federal court ruled in favor of a company that was the subject of lawsuit alleging that their incentive plan had not been properly approved by shareholders for Section 162(m) purposes. The plaintiff argued that because Section 162(m) requires the plan to be approved by the company’s shareholders, all shareholders–even those holding non-voting shares–should have been allowed to vote on it. Shareholder votes are governed by state law but the plaintiff attorney argued that the tax code preempted state law on this matter. Luckily the judge did not agree.
The plaintiff also argued that the company’s board violated their fiduciary duties because they used discretion to reduce the payments made pursuant to awards allowed under the plan. The plaintiff stipulated that this violates the Section 162(m) requirement that payments be based solely on objective factors. In a suit like this, the plaintiff attorney represents a shareholder of the company; it seems surprising that a shareholder would be upset about award payments being reduced–go figure. In any event, it’s fairly well established that negative discretion is permissible under Section 162(m) and the judge dismissed this claim.
Glass Lewis Policy Update Glass Lewis has posted their updated policy for 2014. For US companies, the policy was updated to discuss hedging by execs (spoiler alert: Glass Lewis doesn’t like it) and pledging (they could go either way on this). With respect to pledging, Glass Lewis identifies 12–count ’em, that’s 12–different factors they will consider when evaluating pledging by execs.
The policy was also updated to discuss the SEC’s new rules related to director independence and how the new rules impact Glass Lewis’s analysis in this area. Although we now have three perfectly good standards for director independence (Section 16, Section 162(m), and the NYSE/NASDAQ listing standards), Glass Lewis has developed their own standards and they’re sticking to ’em. I’m sure I’ve asked this before, but really, how many different standards for independence do we need? I’m not sure director independence is the problem here.
Should Your Plan Limit Awards to Directors? As you are getting this year’s stock plan proposal ready for a shareholder vote, one thing to consider is whether to include a limit on awards to directors. In 2012, a court refused to dismiss one of the plaintiff’s claims in Seinfeld v. Slager because the plan did not place sufficient limits on the grants directors could make to themselves and, thus, were not disinterested in administration of the plan, at least with respect to their own grants.
Each study was comprised of U.S. public companies across a variety of sectors. Frederic W. Cook’s study spanned 240 companies, and The Conference Board (et al) surveyed 334 companies.
Size Does Matter
In general, one “rule of thumb” was confirmed: that “compensation levels vary primarily based on company size, while the structure of compensation is influenced by both company size and industry.” (Frederic W. Cook). Both studies presented similar results regarding the prevalence of director equity compensation by industry. While not every industry had a clear trend in terms of cash to stock ratios, the financial services industry clearly utilized the least amount of equity (less than 45%) in its compensation approach, and the technology sector utilized the most: approximately 70% of director compensation in this industry is stock based, according to both reports. When it comes to the blend between cash and stock compensation, it turns out company size does seem to be a factor, more so than industry. Larger companies were more likely to have a mix of cash, stock awards and stock options. Smaller companies reflected a more cash heavy compensation mix.
Stock Awards Rule!
The dominant equity compensation vehicle in use for directors across the board (no pun intended!) is full value stock awards (or units). Stock option grants to directors are minimal in most industries (utilized by less than 20% of retail, financial services and industrial companies, according to Frederic W. Cook). The technology sector’s trends were a bit different: companies in this industry predominantly issue stock awards as part of the compensation mix, yet, about 42% of them also issue stock options to their directors. That’s probably not surprising, given that the technology sector has long been assertive in emphasizing various forms of stock benefits as a component of overall compensation.
The Trend Continues: Stock Ownership Guidelines
We’ve previously blogged about the continuing uptick in the number of companies adopting share ownership guidelines for executives and directors. Both studies reported that a majority of respondents (greater than 50%) had stock ownership guidelines for directors in place. According to The Conference Board (et al), the most widely utilized type of guideline is that based on a multiple of the director’s annual retainer. One study noted a smaller related emerging trend – the implementation of a retention ratio or holding period in combination with their ownership guidelines. About 15% of companies analyzed in the Frederic W. Cook study reported having some form of retention ratio or holding period; with 12% utilizing such ratios or holding period in direct conjunction with their ownership guideline policies. This is a trend to watch, and seems very likely to continue to gain momentum.
Your outside directors should be making estimated tax payments to the IRS on compensation they receive from your company in exchange for their services as an outside director. This includes income realized from equity compensation. Sometimes companies are tempted to withhold taxes on outside director stock transaction. At face value, this may appear to be simple common sense–we know that they will owe taxes, why not facilitate a sell-to-cover or withhold shares to cover those tax payments? The truth is that withholding taxes on outside director transactions is something that your company really should not be doing.
Why not withhold shares?
There has recently been a lot of focus on the accounting consequences of withholding shares above the statutory minimum, because this triggers liability accounting under FAS123(R) (see Paragraph 35). Many companies are struggling with this issue when it comes to share withholding on restricted stock in locations where there is no flat statutory tax rate associated with stock transactions. In the case of non-employees, any taxes withheld will be above the statutory minimum. Therefore, if you withhold shares on a transaction made by an outside director, then the entire grant would be classified and accounted for as a liability. Even worse, if you establish a pattern of allowing shares to be withheld above the minimum statutory required tax obligation, then it is possible that you will trigger liability accounting for the entire plan.
Why not withhold FIT?
So, what about facilitating a sale of shares to help the outside director cover taxes due? As attractive as that may sound, this also is a problem for both the company and the outside director. In addition to the general issues surrounding excess tax payments, reporting the income and tax withholding will prove to be a challenge. Payments for services made to non-employees must be reported on a Form 1099-MISC. You can’t properly report that federal tax payment on a 1099-MISC. This is because there is no provision in the tax regulations for withholding taxes on payments made to non-employees. Additionally, if you withhold federal income tax, then the IRS may determine that FICA and FUTA should also have been withheld, which could result in penalties for the company.
Why not withhold FICA?
This is a bad idea all around–bad for the company and bad for the director. The outside director will need to pay both the income taxes and the self-employment taxes on his or her equity compensation from your company. Self-employment tax includes both the FICA payment and what would be the company’s matching payment. If you withhold FICA at the time of the transaction, it won’t exempt the outside director from also having to pay the self-employment tax on that same income. For the company, if FICA is withheld, then the IRS is going to expect to see a matching company payment. Failing to make that matching payment could result in penalties for the company.
Why not just report everything on a W-2?
Reporting payments made to a non-employee on a W-2 goes against Regulation §1.6041-2(a)(2), which specifically states that the W-2 is for reporting payments made to an employee. Additionally, failing to report the income on a Form 1099 puts the company’s tax deduction in jeopardy–the company would need to prove that the outside director had properly reported the income and paid the income taxes and self-employment taxes on it in order to receive the corporate tax deduction.
Ah, but there is an exception.
If your outside director received a stock grant as an employee (before becoming an outside director), then the some or all of the income from a transaction on that grant may be subject to tax withholding and be reported on a W-2.
We have several great resources on the NASPP site to help you deal with your company’s tax withholding and reporting obligations. Our best resource is the NASPP Tax Withholding and Reporting portal. You can also go back and review our annual webcasts on Tax Withholding and Reporting–the 2008 Webcast has fantastic points on dealing with non-employees! Also, don’t forget about the NASPP Discussion Forum. Take advantage of the key word search to find questions other members have submitted; you might find that the answer to your question is already available.