Advantages of Performance-Based Compensation. Performance-based pay offers a number of advantages to a hospitality industry employer seeking to capitalize on its strategic plan and leverage its employees’ strengths. A key advantage of this type of compensation is that it requires an organization to set goals. In creating a framework to reward performance, an organization’s leaders may focus on market-based benchmarks, internal priorities, or customer preferences. Employee interests are aligned with employer objectives under a properly designed compensation program.
Both executives and mid- and entry-level employees can be motivated through a variety of performance- based pay vehicles. Short-term and long-term incentives historically have played an important role in the compensation packages of hotel industry key executives.1 In addition, the positive effect of pay-for-performance on hotel industry employees was cited in a recently published study. The authors found that employees exhibited more positive work attitudes when they perceived a high pay-for-performance link.2
A secondary, but significant, advantage of performance- based compensation is that this type of pay receives special treatment in some contexts under the Internal Revenue Code (“IRC”). This article will discuss how incentive pay has preferred status for certain tax compliance and deduction purposes.
Types of Performance-Based Compensation. Stock-based compensation is one type of performance- based pay. This type of compensation vehicle includes stock options, stock grants, performancebased vesting of stock grants, phantom equity, performance- based earn-out of phantom shares, and other variations. Cash compensation may also be performance-based. Bonuses linked to attainment of performance goals are one of the most common forms of incentive pay. A performance period can be set by the organization, consistent with the objective sought. Monthly performance periods may work best for some targets; annual or multiyear periods may be appropriate for others. Shortand long-term incentives may be used simultaneously. Some of the tax rules described below require performance periods of at least one year, but shorter incentive periods may nonetheless be a valuable part of an organization’s overall pay strategy.
Advantages Under IRC Section 409A. IRC Section 409A (“409A”) governs “deferred compensation.” 409A was enacted in 2004 and prescribes very specific and complex rules that affect a wide variety of compensation. These rules apply to many types of pay, not just payments under traditional nonqualified deferred compensation plans, such as SERPs or excess benefit plans. 409A applies both to privately-held and public employers. Heavy tax penalties are imposed on the affected employee (409A is not limited to executive-level employees), even though the employee often has little control over the design or operation of the pay arrangement. 409A addresses the time and form of payment of deferred compensation, changes to timing and form of payment, deferral elections, and other aspects of this type of pay. 409A also requires deferred compensation promises to be put in writing.
Performance-based compensation enjoys special treatment under 409A.
Exemption from 409A. Some types of performance-based compensation are not treated as “deferred compensation” under 409A. This is often the best result, because in such a case the compensation will be exempt from compliance with strict rules. One category of performance- based pay exempt from 409A is a stock option granted with a current fair market value exercise price. 409A prescribes guidelines under which non-public companies may establish a compliant fair market value for this purpose. Stock awards subject to IRC Section 83 are also exempt from 409A, provided that the employee does not attempt to defer income inclusion prior to vesting. Exempt stock awards are actual grants of restricted stock – as opposed to phantom shares, stock units, or similar awards that pay out based on stock value but do not constitute “a transfer of property” at the time the award is granted or promised.
Another important category of exempt compensation is an incentive or bonus program where payment occurs within a short time following vesting or earn-out of the award. 409A is very specific about the post-vesting time frame within which payment must occur, i.e., by the 15th day of the third month following the end of the (later of ) the employer’s or employee’s taxable year in which vesting occurs. Compensation of this sort is referred to as a “short-term deferral.” This exemption is very useful in structuring many types of incentive and performance-driven pay programs.
Short-term deferrals exempt from 409A also are not subject to the “written plan” requirement for deferred compensation. To the extent feasible, an employer still may wish to put in writing incentive plans that would constitute short-term deferrals. Doing so potentially allows the employer to comply with 409A where the exemption is lost because payment in a given year occurs after the 15th-day-ofthe- third-month time frame described above.
More Lenient Deferral Deadline. Deferrals of certain performance- based bonuses enjoy a more lenient deadline for deferral elections. One aspect of deferred compensation covered by 409A is an employee’s election to defer receipt of pay. Deferral of salary generally must be made prior to the calendar year in which the salary is earned. Deferral of bonus generally must be made prior to the calendar year in which the bonus begins to be earned. The bonus rule contemplates single- and multi-year bonus periods. Fiscal year compensation may be deferred before the beginning of the fiscal year in which services will be performed, if certain conditions are met. In all cases, including the exception described below, an election to defer must become irrevocable by the plan’s terms before the deadline.
An important exception to these election deadlines is for performance- based compensation, as defined in Treasury Regulations under 409A. Deferrals of performance-based compensation may be made as late as six-months prior to the end of the performance period, as long as the election is made before the compensation is substantially certain to be paid. This later deadline can be applied to pay subject to a performance period of at least 12 months. For a multi-year performance cycle, the later deadline would fall well into the cycle, allowing executives and other employees greater flexibility in planning whether and how much to defer.
Compensation may be performance-based for this purpose even if based on subjective performance criteria, provided that the criteria are bona fide and relate to the performance of the employee, a group of individuals including the employee, or a business unit (including the entire employer organization) for which the employee provides services. Whether subjective performance goals have been met cannot be determined by the employee, a relative of the employee, or a person under the employee’s or a relative’s control.
To use the special election timing rule, performance criteria must be set forth in writing not later than 90 days after the beginning of the performance period. Compensation committee or shareholder approval of the criteria is not required for this purpose. Performance-based compensation must be contingent on attainment of the goals – i.e., it cannot be payable whether or not the goals are met, except in the case of death, 409A-defined disability, or 409A-defined change of control. An employee must perform services continually from the later of the beginning of the performance period or the date the performance criteria are set through the date the election is made.
Designing compensation arrangements to satisfy or qualify for exemptions from 409A is feasible and can be fairly straightforward with certain types of incentives. 409A’s reach is broad, however, and penalties for violating the rules are severe – including where the violation is an inadvertent failure to qualify for the short-term deferral or another exception discussed above. It is essential for an employer to seek the advice of a qualified professional to ensure compliance or exempted status for its compensation programs.
Advantages Under IRC Section 162(m). IRC Section 162(m) (“162(m)”) limits the deduction for pay to top executives of public companies to $1 million per year. Performance-based compensation is excluded when calculating pay for purposes of the 162(m) limit.
Types of Performance-Based Compensation Under 162(m) Requirements. Stock options granted with a current fair market value exercise price are performance-based if the company’s stock plan contains stated per-individual limits on option grants and meets shareholder approval and certain other requirements. The stated limit requirement can be accomplished easily with advance planning by the employer. Special rules apply to cancellations and repricings of options. Amounts payable on a commission basis may qualify for 162(m)’s performance- based compensation exclusion as well.
Stock grants that vest on attainment of performance goals and cash-based compensation can also be performance- based for 162(m) purposes with proper plan design and grant procedures. Performance metrics, e.g., return on equity, market share, stock price, etc.; maximum annual grant levels; and the class of eligible employees need to be pre-determined and approved by shareholders in advance of payment. Often, the metrics, grant levels and eligibility are included in a shareholder-approved incentive plan. Specific levels of attainment for a particular executive can be set year-by-year outside of the plan. Performance can be measured as improvement or even as maintenance of the status quo – for the executive, a business unit, or the organization as a whole. The compensation payable under the award must be objectively determinable (so that a third party could calculate the payment), although discretion to adjust the payment downward is permissible.
Award terms must be determined, and satisfaction of criteria must be certified, by a compensation committee of the employer’s Board of Directors that satisfies the requirements for independence under 162(m). Goals for a particular executive must be established in writing no more than 90 days after the start of the performance period (or, if sooner, before more than 25 percent of the performance period has elapsed). The outcome of the performance goal must be substantially uncertain at the time the committee establishes the goal. With limited exceptions, compensation is not performancebased if it may be paid whether or not goals are met, e.g., where vesting occurs or payment will be made upon retirement prior to the end of the performance period.
Where performance-based compensation is granted under a plan that includes the metrics, maximum grant levels, and eligibility requirements – but that allows the compensation committee to set and change performance targets, e.g., 5 percent annual increase in share price – periodic reapproval by shareholders is required. Material terms of the plan, including the performance metrics, etc., would need to be disclosed to and reapproved by shareholders no later than the first shareholder meeting in the fifth year after the year in which the shareholders previously approved the plan. Thus, a plan that originally was approved in 2006 would need to be submitted to shareholders for reapproval no later than the first shareholder meeting in 2011. Midfive- year cycle changes to approved metrics, the eligible class of employees, or maximum grant levels must also be approved before payment under the changed elements, in order for the payment to qualify as performance-based under 162(m). Although 162(m) requires shareholder approval as described above, public employers should ensure that any additional and more frequent securities disclosure obligations are satisfied. Financial accounting consequences should also be factored into any incentive compensation strategy.
Like rules under 409A, requirements for performance- based pay status under 162(m) are technical but can be satisfied for a wide variety of incentive pay arrangements. Hotel and other hospitality industry employers who use targeted incentives for their executives should ensure that their programs are tailored to take advantage of the special treatment for performance-based pay.
IRS Circular 230 Disclosure. To comply with requirements imposed by the Internal Revenue Service, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.