How Employee Compensation Works

Stock Options/Profit Sharing

Often used as a tool to retain employees, stock options have a growing appeal in today's job market. Depending on the business and industry, stock options can be a very valuable and enticing benefit to offer employees and potential employees. Deciding to offer stock options is a no-brainer; deciding on the type of option plan is another story.

There are three classes of stock options: incentive stock options (ISO), employee stock purchase plan options, and nonqualified options.

The most popular plans are ISOs and nonqualified plans. With both of these plans, the employee is offered a specific number of shares that they can purchase (exercise) on a specified date. The shares can be purchased at the value of the stock at the time the option was granted. So, if the stock's value has increased when the employees exercise their option, then they get a good deal; if not, then the stock options are worth nothing.

These two plans differ in the way the money is taxed. With ISOs, the employees pay no taxes until they later sell the shares they have bought (exercised). At that time, any money they made off of the transaction is subject to capital gains tax instead of income tax. They must, however, make sure they don't sell the shares for at least two years after the time the option was granted or within one year after they exercised their option (bought the stock). Another thing to consider is that there is no corporate deduction when the employee exercises the option.

With nonqualified plans, the tax situation is different. Employees will have to pay income tax on any gains they made when they exercised their options (assuming the employee is making a profit based on the current value of the stock). For example, if the stock was valued at $2 per share when the options were granted and is valued at $5 when the options are exercised, then ordinary income tax must be paid on the gain of $3 per share. There can also be a corporate deduction on the same amount. Later, if the employee keeps the stock and it increases more in value, then they will only owe capital gains tax on the additional increase in value when they sell.

Employee stock purchase plans are another option for employers who want to lure new recruits. Unlike the ISOs and nonqualified plans, employee stock purchase plans are usually offered to all eligible employees. Employees can purchase the stock at usually about 85% of its market value. Most companies allow employees to purchase stock amounts up to 10% of total pay, and offer payroll deductions for payment.

Another lesser-known option particularly appealing for small and private companies is the phantom-stock plan. Phantom-stock plans operate in a similar manner as the other stock options, but the risk of sharing equity in the company isn't there. You can issue shares to your employees at a set price based on your company's current value, then on a specified future date reevaluate the company's value. If the stock has risen and the employee wants to sell, then you cut a check to the employee for the increased amount. Your employee will pay tax on the additional "wages," and your company can take a tax deduction.

Profit Sharing Plans

About 40% of companies offer profit sharing plans. Profit sharing programs require setting up a formula for distribution of company profits. The formula is usually based on 5% to 6% of the employee's salary. They usually include a vesting period of up to seven years. The good thing about profit sharing plans is that they allow you to decide if and how much your company contributes to the plan. During less profitable years, you may opt to not contribute. It also lets you control how the money is invested and is not as expensive to administer as other plans.

Employee Stock Ownership Plans (ESOPs)

ESOPs are the most common form of employee ownership in the United States. They allow your employees to own a part of the company without requiring them to purchase stock. Your company can be either public or private, and stock is usually transferred to the employees through annual contributions. ESOPs, like the other employee stock ownership methods, can improve your bottom line through employees' heightened awareness and vested interest in helping the company be successful. If you are interested in transferring some or all ownership to your employees, then this might be a good option for your company. The contributions are tax deductible, you can borrow against the ESOP, and stock owners can sell their shares back to the company when they leave and escape paying taxes if the money from the sale is transferred into another security. ESOP accounts are tax deferred until retirement.

Next, we'll talk about retirement plans.