For today’s blog, I discuss trends in the use of equity in compensation outside directors, as noted by consulting firm Frederic W. Cook & Co. in its 2016 Director Compensation Report.
The study includes 300 public companies of varying sizes in the financial services, industrial, retail, technology, and energy sectors. FW Cook has been publishing this study annually for well over a decade (the earliest report I can find on their website is from 2001). The 2016 study found that on average more than half (57%) of total director compensation is paid in the form of equity awards (in general, the larger the company, the greater the percentage of stock compensation for directors). It’s worth looking at a few of the trends in the use of equity in director compensation.
Trend #1: Restricted Stock/Unit Awards
With respect to the use of restricted stock and units versus stock options, the study found that:
Most of the studied companies (more than 80%) grant only restricted stock/RSUs to directors (no stock options).
Use of full-value-only equity programs increased year-over-year among small-cap companies while staying flat for large- and mid-cap companies. Option-only programs declined in prevalence at large- and small-cap companies versus last year.
At technology companies in the study, which have historically granted stock options more than companies in other sectors, there has been a significant swing toward the granting of only restricted stock/RSUs to directors (up from 78% to 85% of those companies). The leading sector for stock options is now the industrial group, where 18% of the companies grant stock options to directors.
Two Other Trends
A couple of other trends you should think about for your director compensation, if you aren’t doing these things already:
Compensation Limits: About a third of studied companies now include an annual limit on compensation paid to directors under their equity plans (in increase from prior years—by way of comparison, only 23% of respondents to the NASPP/Deloitte Consulting 2014 Domestic Stock Plan Administration survey included such a limit on director awards). Companies have been adding these limits in response to shareholder litigation over excessive director pay. FW Cook found that these limits are also increasingly covering total pay, not just equity awards.
Ownership Guidelines: A majority of studied companies have director stock ownership guidelines. The study notes that these guidelines have been ubiquitous at large-cap for many years and usage at small- and mid-cap companies has increased.
Does your company issue grants to outside directors out of the same plan that you issue grants to executives and other employees? If do you, does the plan expressly limit the number of shares that can be granted to directors over a specified period of time?
If it doesn’t, you aren’t alone. According to the NASPP/Deloitte Consulting 2014 Domestic Stock Plan Administration Survey, 77% of respondents’ plans don’t include a limit on grants to outside directors. But a recent spate of litigation, including a lawsuit that Facebook recently agreed to settle, suggest that maybe companies should rethink this practice.
What Litigation?
The lawsuits cover a range of issues related to stock and executive compensation. Some suits allege excessive compensation and some allege deficiencies over stock plan disclosures or proxy disclosures. In addition to Facebook, companies that have been targeted in these suits include Republic Services, Citrix Systems, Goldman Sachs, Cheniere Energy, and Unilife. One common denominator in all of these suits, however, is that the plaintiffs allege that because the company’s outside directors can receive unlimited awards under the plans, they aren’t disinterested administrators of the plan.
Why Is Disinterested Administration Important to these Lawsuits?
These lawsuits are all “derivative” actions (which are lawsuits brought by a shareholder on behalf of the corporation, usually alleging that management is doing something that is to the detriment of the corporation). In a derivative lawsuit, the plaintiff has to meet a “demand” requirement for the suit to proceed. Demand means that the plaintiff asked the company to investigate the matter and the company either refused to investigate or the shareholder doesn’t agree with the outcome of the investigation. In a lot of cases, these suits never get past the demand stage.
But, there is an exception to the demand requirement in lawsuits over stock compensation plans. Can you guess what it is? Yep, that’s right, the demand requirement is excused if a majority of the directors administering the plan lack independence. Plaintiffs are claiming that directors who can receive unlimited awards under a plan aren’t disinterested.
What Happened with Facebook?
Well, first of all, once a suit gets past the demand stage, it gets expensive. So the first thing is that Facebook had to spend a bunch of money on their own lawyers. That, in and of itself, is reason enough to want to keep any of these suits from getting past the demand stage.
The settlement Facebook agreed to includes the following provisions:
Corporate governance reforms, including (A) an annual review of all compensation (cash and equity) paid to outside directors, (B) engage a compensation consultant to advise the company on this review and on future compensation to be paid to outside directors, and (C) use the results of the review to make recommendations to the board on future compensation to outside directors.
Submit the 2013 grants to outside directors to shareholder vote (these grants were the subject of the lawsuit). Hopefully the shareholders approve them–I’m not sure what happens if they don’t (but I’m pretty sure it would make a good blog entry).
Submit an annual compensation program for directors to shareholders for approval. The program has to include specific amounts for equity grants and has to delineate annual retainer fees. As far as I can tell, this is a one-time requirement, for Facebook’s 2016 meeting; if I understand the settlement correctly, the board is allowed to make changes to the program in the future, commensurate with the results of the annual review required under #1 above.
Pay an award of attorneys’ fees and expenses to plaintiff’s counsel not to exceed $525,000 (this is, of course, in addition to whatever Facebook has paid to its own counsel).
A Simple Fix
The simple fix to avoid all of this is to have a limit on the awards that can be issued to outside directors in your plan. If your company is submitting a stock plan to shareholder vote this year, it is worth considering adding a limit like this to your plan.
Thanks to Mike Melbinger of Winston & Strawn for providing a handy summary of the Facebook settlement, as well as a number of the other lawsuits, in his blog on CompensationStandards.com (see “Follow-Up on Facebook Litigation Settlement,” January 29, 2016).
Last week, I covered the basic rules that apply for tax purposes when options are exercised or awards pay out after an individual has changed status from employee to non-employee or vice versa. Today I discuss a few more questions related to employment status changes.
Is it necessary that the consulting services be substantive?
When employees change to consultant status an important consideration is whether the consulting services are truly substantive. Sometimes the “consulting services” former employees are providing are a little (or a lot) loosey goosey (to use a technical term). For example, sometimes employees are allowed to continue vesting in exchange for simply being available to answer questions or for not working for a competitor. It this case, it’s questionable whether the award is truly payment for consulting services.
A few questions to ask to assess the nature of the consulting services former employees are performing include whether the former employee has any actual deliverables, who is monitoring the former employee’s performance and how will this be tracked, and will the award be forfeited if the services are not performed.
If the services aren’t substantive, it’s likely that all of the compensation paid under the award would be attributable to services performed as an employee (even if vesting continues after the employee’s termination) and subject to withholding/Form W-2 reporting.
Is the treatment different for an executive who becomes a non-employee director?
Nope. The same basic rules that I discussed last week still apply. The only difference is that I think it’s safe to presume that the services performed as an outside director will be substantive (unless the director position is merely ceremonial).
What about an outside director who is hired on as an executive?
The same basic rules still apply, except in reverse. For options and awards that fully vested while the individual was an outside director, you would not need to withhold taxes and you would report the income on Form 1099-MISC, even if the option/award is settled after the individual’s hire date.
For options and awards granted prior to the individual’s hire date but that vest afterwards, you’d use the same income allocation method that I described last week. As I noted, there are several reasonable approaches to this allocation; make sure the approach you use is consistent with what you would do for an employee changing to consultant status.
What about a situation where we hire one of our consultants?
This often doesn’t come up in that situation, because a lot of companies don’t grant options or awards to consultants. But if the consultant had been granted an option or award, this would be handled in the same manner as an outside director that is hired (see the prior question).
What if several years have elapsed since the individual was an employee?
Still the same; the rules don’t change regardless of how much time has elapsed since the individual was an employee. The IRS doesn’t care how long it takes you to pay former employees; if the payment is for services they performed as employees, it is subject to withholding and has to be reported on a Form W-2.
So even if several years have elapsed since the change in status, you still have to assess how much of the option/award payout is attributable to services performed as an employee and withhold/report appropriately.
What if the individual is subject to tax outside the United States?
This is a question for your global stock plan advisors. The tax laws outside the United States that apply to non-employees can be very different than the laws that apply in the United States. Moreover, they can vary from country to country. Hopefully the change in status doesn’t also involve a change in tax jurisdiction; that situation is complexity squared.
Finally, When In Doubt
If you aren’t sure of the correct treatment, the conservative approach (in the United States—I really can’t address the non-US tax considerations) is probably going to be to treat the income as compensation for services performed as an employee (in other words, to withhold taxes and report it on Form W-2).
What is the US tax reg cite for all of this?
My understanding is that none of this is actually specified in the tax regs—not even the basic rules I reviewed last week. This is a practice that has developed over time based on what seems like a reasonable approach.
For today’s blog entry, I discuss how stock plan transactions are taxed when they occur after the award holder has changed employment status (either from employee to non-employee or vice versa). This is a question that I am asked quite frequently; often enough that I’d like to have a handy blog entry that I can point to that explains the answer.
The basic rule here is that the treatment is tied to the services that were performed to earn the compensation paid under the award. If the vesting in the award is attributable to services performed as an employee, the income paid under it is subject to withholding and reportable on Form W-2. Likewise, if vesting is attributable to services performed as a non-employee, the income is not subject to withholding and is reportable on Form 1099-MISC.
Where an award continues vesting after a change in status, the income recognized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) is allocated based on the portion of the vesting period that elapsed prior to the change in status.
For example, say that an employee is granted an award of RSUs that vests in one year. After nine months, the employee changes to consultant status. The award is paid out at a value of $10,000 on the vest date. Because the change in status occurred after three-fourths of the vesting period had elapsed, 75% of the income, or $7,500, is subject to tax withholding and is reportable on the employee’s Form W-2. The remaining $2,500 of income is not subject to withholding and is reportable on Form 1099-MISC.
What if the award is fully vested at the time of the change in status?
In this case, the tax treatment doesn’t change; it is based on the award holder’s status when the award vested. For example, say an employee fully vests in a award and then later terminates and becomes a consultant. Because the award fully vested while the individual was an employee, the award was earned entirely for services performed as an employee and all of the income realized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) is subject to withholding and is reportable on Form W-2.
This is true no matter how long (days, months, years) elapse before the settlement. Under Treas. Reg. §31.3401(a)-1(a)(5), payments for services performed while an employee are considered wages (and are subject to withholding, etc.) regardless of whether or not the employment relationship exists at the time the payments are made.
What is the precise formula used to allocate the income?
There isn’t a precise formula for this. We asked Stephen Tackney, Deputy Associate Chief Counsel of the IRS, about this at the NASPP Conference a couple of years ago. He thought that any reasonable method would be acceptable, provided the company applies it consistently.
The example I used above is straight-forward; awards with incremental vesting are trickier. For example, say an employee is granted an NQSO that vests in three annual installments. 15 months later, the employee changes to consultant status.
The first vesting tranche is easy: that tranche fully vested while the individual was an employee, so when those shares are exercised, the entire gain is subject to withholding and reportable on Form W-2.
There’s some room for interpretation with respect to the second and third tranches, however. One approach is to treat each tranche as a separate award (this is akin to the accelerated attribution method under ASC 718). Under this approach, the second tranche is considered to vest over a 24-month period. The employee changed status 15 months into that 24-month period, so 62.5% (15 months divided by 24 months) of that tranche is attributable to services performed as an employee. If this tranche is exercised at a gain of $10,000, $6,250 is subject to withholding and reported on Form W-2. The remaining $3,750 is reported on Form 1099-MISC and is not subject to withholding. The same process applies to the third tranche, except that this tranche vests over a 36-month period, so only 41.7% of this tranche is attributable to services performed as an employee.
This is probably the most conservative approach; it is used in other areas of the tax regulation (e.g., mobile employees) and is also used in the accounting literature applicable to stock compensation. But it isn’t the only reasonable approach (just as there are other reasonable approaches when recording expense for awards under ASC 718) and it isn’t very practical for awards with monthly or quarterly vesting. It might also be reasonable to view each tranche as starting to vest only after the prior tranche has finished vesting. In this approach, each tranche in my example covers only 12 months of service. Again, the first tranche would be fully attributable to service as an employee. Only 25% of the second tranche would be attributable to services as an employee (three months divided by 12 months). And the third tranche would be fully attributable to services performed as a consultant.
These are just two approaches, there might be other approaches that are reasonable as well. Whatever approach you decide to use, be consistent about it (for both employees going to consultant status as well as consultants changing to employee status).
Read “Employment Status Changes, Part II” to learn about additional considerations and complexities relating to changes in employment status.
On January 16, the SEC approved the new NYSE and NASDAQ listing standards relating to compensation committee independence. As noted in the NASPP’s alert on the original proposals (“Exchanges Issue New Standards for Compensation Committee Independence“), the new standards include three primary requirements:
The compensation committee must be comprised of independent directors, based on a number of “bright line” tests (many of which were already applicable to independent directors under each exchange’s prior listing standards) as well as additional factors that the SEC suggested should be considered in determining a director’s independence. Also, NASDAQ will now require a separate compensation committee (the NYSE already required this).
The compensation committee must have authority and funding to retain compensation advisors and must be directly responsible for appointment, compensation, and oversight of any advisors to the committee.
The committee must evaluate the independence of any advisors (compensation consultants, legal advisors, etc.).
The final rules make only a few minor changes to the original proposals, including clarifying that the compensation committee will not be required to conduct the required independence assessment as to a compensation adviser that acts in a role limited to:
consulting on a broad-based plan that does not discriminate in favor of executive officers or directors of the company, and that is available generally to all salaried employees; or
providing information (such as survey data) that is not customized for a particular company or that is customized based on parameters that are not developed by the adviser, and about which the adviser does not provide advice.
Public companies now need to assess whether the compensation consultants and other advisors engaged by their compensation committee raise any conflicts of interest and disclose any identified conflicts in their proxy statement (for annual meetings after January 1, 2013 at which directors will be elected). Although not required, where no conflict of interest is found, we expect that many companies will include a disclosure to indicate this.
In his Proxy Disclosure Blog on CompensationStandards.com, Mark Borges of Compensia highlights a recent disclosure on this topic in Viacom’s proxy statement, which might be useful to review as you draft your own disclosure (if this isn’t your gig, perhaps you can score some points by forwarding it on to the person that will be drafting this disclosure).
This week, we feature another installment in our series of guest blog entries by NASPP Conference speakers. Today’s entry is written by Narendra Acharya of Baker & McKenzie, who will lead the session “50 Ways to Pay (and Tax) Your Board of Directors.”
While Board director compensation does not receive the same level of media focus as executive compensation, it does not escape scrutiny (see “Companies With the Highest-Paid Boards of Directors,” The Bottom Line, June 15, 2012). Earlier this year, director compensation was also the subject of a recent unsuccessful shareholder proposal to expand Say-on-Pay to director compensation (see Proposal 5 in Apple’s 2012 proxy statement).
At the same time, director compensation varies across companies to a greater degree than executive compensation practices and is more likely to be more influenced by the company’s historical practice than the company’s executive compensation practices. As a result, there can be substantially greater differences in the structure of director compensation than executive compensation, even within the same industries. Director compensation correlates more with company size than with industry (see “Annual Survey Reveals Emergence of New Compensation Practices,” The Conference Board, November 2, 2011.) These differences in the structure include different vesting practices as well as the availability of deferral elections.
Even when director grants are made under the same equity compensation plan that is used for employee awards, the process and procedures for implementing grants often is quite separate from the employee grant procedures and the grants may be administered by a group that does not generally administer employee awards.
As the makeup of boards becomes more international–recent surveys indicates that up to 10% of non-employees directors are not U.S. nationals–more companies need to address the specific US tax requirements that apply when non-employee directors are a US nonresident alien for income tax purposes. In the absence of specific tax treaty relief, companies can be required to withhold at a flat 30% rate on all of the director compensation paid to US nonresident alien directors. This can be a surprising result–in contrast to the treatment of compensation paid to US citizen/resident directors.
At the 20th Annual NASPP Conference, the session “50 Ways to Pay (and Tax) Your Board of Directors” will provide a multi-disciplinary review of trends in pay practices for directors. The session will also provide an overview of the US tax consequences of directors’ compensation including the use of stock and deferral programs. Finally, the session will address the unique US tax issues related to directors that are not residents of the United States for income tax purposes.
This week, we feature another installment in our series of guest blog entries by NASPP Conference speakers. Today’s entry is written by Ellie Kehmeier of Steele Consulting, who will lead a session on Section 162(m) at the NASPP Conference.
If any code section warrants the old adage “the devil is in the details,” it’s got to be Section 162(m), which disallows corporate tax deductions for compensation paid to top executives in excess of $1 million. Complying with the requirements of this section can be devilishly tricky, especially when it comes to trying to preserve tax deductions for equity awards by meeting the exception for performance-based compensation.
My fellow panelists, Danielle Benderly of Perkins Coie and Art Meyers of Choate Hall & Stewart, and I have presented on 162(m) before. We realize that, while it’s an incredibly important topic, it can also be an incredibly dry topic. For our session in New Orleans, we plan to bring 162(m) to life with lively back-and-forth discussion of issues raised in a detailed case study we’re putting together for this session that hits on many of the stumbling blocks that we’ve seen trip up HR, legal, and tax professionals alike.
For example, while most people understand that stock options and SARs generally qualify as performance-based compensation as long as the awards aren’t granted with a discounted exercise price, it’s easy to overlook the additional requirement that the compensation committee that grants equity awards to 162(m) covered employees must be comprised solely of two or more “outside directors”. Easy enough, you might think: if we’re already following the NASDAQ and NYSE listing requirements for independent directors, we should be okay, right? Not so fast! The tax rules are different, and in some respects more stringent, than the exchange listing requirements. For example, if your company pays any amount, no matter how immaterial, to an entity that is more than 50% owned by a director (directly or beneficially)–such as a caterer or florist that happens to be owned by a family member of that director–then you have a problem! If your compensation committee fails to meet these requirements, then all the equity awards granted by the committee similarly fail. That’s a harsh result, and can cause a pretty big hit to your company’s bottom line!
We will also use our case study to explore other outside director challenges, as well as tricks and traps related to when performance goals need to be established, if and how they can be changed, and when and how to get shareholder approval. For example, do your plans explicitly address how your compensation committee can adjust performance goals to reflect the effect on an acquisition? Can your company pay bonuses outside of your performance plan if the established goals are not met? Can you structure compensation for executives hired mid-year to comply with 162(m)? Our case study will also address the transition rules for newly public companies. Finally, we’ll discuss planning opportunities and best practices, and cover recent developments, including proposed 162(m) regulations that may be finalized by the time we meet in New Orleans. We’ll see you there!
A few weeks ago, a paragraph caught my eye in a McGuireWoods alert about President Obama’s revenue proposals for 2012. Under the proposals, independent contractors that receive more than $600 per year from a company would be able to require the company to withhold federal income tax on their payments. Contractors would not only be able to require the withholding but would also be permitted to determine the withholding rate.
I know, I know–you can’t imagine that any contractors would actually want taxes withheld and some of you are also thinking that your company doesn’t grant awards to contractors so this doesn’t apply to you. But, you might want to think again. As far as I know, the tax code doesn’t distinguish between different types of non-employees. You either are an employee or you aren’t. So while the proposal uses the term “independent contractor,” it’s possible that, when implemented, this would also allow outside directors to request that taxes be withheld from their compensation.
Which is interesting because a number of stock plan administrators have told me their outside directors want taxes withheld on their stock awards. Usually the directors want to use some of the stock in their awards to cover the taxes, either through share withholding or a sale of the award shares. In some cases, they also just don’t want to hassle with estimated tax payments.
Thus, I think there’s a reasonable possibility that some outside directors would avail themselves of the opportunity to have the company withhold taxes. Of course, share withholding would still be a problem–since the withholding is voluntary, any taxes that are withheld would be in excess of minimum statutory withholding rates, triggering liability treatment under ASC 718 in the event of share withholding. (If the directors sell their award shares on the open market to cover the taxes, liability treatment won’t be a problem. Likewise, of course, if the directors pay the taxes in cash–but that’s no fun.) While companies would be forced to accommodate the withholding request, they presumably would not have to allow the directors to utilize share withholding, even if they allow share withholding for employees.
It has also occurred to me that this might be a way for non-employees to flaunt the estimated tax payment system. Non-employees holding stock options might skip making any estimated payments throughout the year and, at year-end, exercise an option and have the company withhold enough of their proceeds to cover the tax payments they should have made earlier. We’ve seen this type of behavior before–see my Dec 9, 2008 blog, “Excess Tax Withholding – Part 2.”
No Need to Panic Yet
We are a long way from this being a reality–at this point, it’s just a proposal; who knows if it will ever come to pass. And there are many questions that will have to be addressed before it can be implemented, such as whether or not the proposal applies to all non-employees including outside directors or whether the IRS will somehow limit it to “independent contractors.” No need to start changing your procedures yet–this is just something to keep an eye on.
They’re Here It’s always a little unnerving to get mail from the IRS, but this time proved to be nothing to worry about. My copies of Forms 3921 and 3922 have arrived. I was out of town for the past week, so I’m not sure exactly when they arrived. But, for those of you filing on paper (presumably you all requested a 30-day extension of the filing deadline), the forms are now available, in plenty of time to file by March 30. You can order your copies via the IRS website and you should receive them within 7 to 15 days.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Attend your local NASPP chapter meetings in Dallas, Orange County, and San Francisco. I’ll be at the San Francisco meeting and Robyn Shutak, the NASPP’s Education Director, will be at the Orange County meeting–we hope to see you there.