One of the top challenges currently facing community banks is the process of attracting and retaining talent for their key executive positions. Executive compensation plans play a significant role in attracting and retaining the key personnel required to manage a successful financial institution.
Ideally, executive compensation plans would balance the executive's focus between short- term and long-term personal and career goals, and create common goals between bank shareholders and the executive. In addition to serving as a means of attracting and retaining talent in key executive positions, these compensation plans also serve as a motivational tool for bank executives, as the executive's compensation is often directly tied to specific performance measures of the bank.
Several Alternatives Available
There are several different alternatives available for financial institutions to choose from when determining which executive compensation plan is right for their situation. The bank's choice will be determined after considering many factors, including whether the current ownership group would rather give up actual equity ownership to the executive, or if they would rather compensate them with cash payments in lieu of equity. The needs and desires of the executives being sought also need to factor heavily in the choice of plan. And finally, the impact on bank capital and the taxation of the plan (for both bank and executive) is another significant factor that is considered in choosing the right executive compensation plan for both the bank and the executive.
Nonqualified Deferred Compensation (NQDC) Plans
This type of plan has historically been popular in community banks. In a typical NQDC arrangement, the bank executive is entitled to cash payments once they retire or reach a specified age. Often, if the executive terminates his employment with the bank prior to the specified age or date, they will not be eligible for the cash payments outlined in the agreement. Thus, it provides incentive for the executive to remain employed at the bank for an extended period of time. These types of arrangements can either be of a defined benefit variety (the post-retirement income stream for the executive is already determined), or the plan can provide for performance measures, so the future cash payments to the executive will depend on the defined performance results.
A NQDC arrangement requires banks to accrue the present value of the liability due the bank executive in accordance with the agreement. This liability grows to a peak amount at the first payout date, and then decreases with each cash payment to the executive. Thus, bank capital is reduced incrementally during the entire life cycle of the NQDC arrangement, from inception and all the way through the payout phase.
The bank does not get to deduct this expense for income tax purposes until it is actually paid in cash to the executive; thus, the tax deduction lags behind the expense reflected on the bank's books. The executive also does not pay income tax on the amounts until actually received in cash. Payroll taxes are paid by the bank and executive as the amounts are vested, which generally occurs incrementally over the accrual period of the arrangement.
Banks and executives all need to be aware of IRC Section 409A requirements. If specific requirements are not met in regard to timing of the payments and the election by the executive to defer cash payments under this plan, a penalty of 20 percent of the plan balance is assessed to the executive. In addition, all amounts deferred after 2004 are taxed immediately to the executive, plus interest from the date of noncompliance. Each specific requirement of IRC Section 409A needs to be carefully addressed in the plan document, and the plan must be operated in accordance with these requirements. If a NQDC arrangement is being considered, bank ownership and executives need to contact their tax advisors to discuss the IRC Section 409A requirements before entering into the arrangement.
Phantom Stock Arrangement
Phantom stock arrangements are very similar to that of a NQDC, except that the future cash payments are not a previously determined amount, but are rather based on bank performance measures. For example, the executive may be granted 1,000 phantom units of bank stock (not actual equity ownership). Assume there are 10,000 total actual equity shares outstanding. This would indicate a phantom 10 percent ownership stake for the executive. Assume further that the plan indicates that the executive's future cash payments will be based on the increase in book value of the bank, from the date of hire through the indicated date of retirement. If the bank increased in book value from the executive's date of hire by $8 million, the executive would then be eligible for an $800,000 cash payment upon retirement or separation of service as a result of the phantom stock arrangement. As the amounts are vested, the bank will record a liability on its books for these calculated amounts and thus reduce bank capital for this liability as it occurs.
Phantom stock arrangements are also subject to the stringent requirements of IRC Section 409A as discussed earlier. This means much attention needs to be paid to the drafting of the plan document and the operation of the plan to assure that these requirements are met.
Stock Bonus Awards
In lieu of cash, a bank ownership group will often award equity stock to the executive. Thus, the bank's ownership group needs to be open to admitting the bank executive to their group as an equity stakeholder. To increase the effectiveness of this type of executive compensation as both a retention and motivational tool, vesting can be made contingent on specific bank performance measures, such as bank stock price, ROA, ROE, asset growth, asset quality, etc.
The bank executive realizes taxable ordinary wage income and the bank receives a tax deduction on the grant of a stock bonus in an amount equal to the fair market value of the stock when the stock awarded is no longer subject to a substantial risk of forfeiture. In addition, the company is subject to withholding requirements applicable to compensation.
If the stock is subject to restrictions (i.e., the executive cannot sell or transfer the stock for a certain period of time), the executive will realize taxable income on the stock award as the restrictions lapse; likewise, the corporation will realize the tax deduction as the stock restrictions lapse. If the executive expects the stock value to increase over the period of time that the restrictions lapse, they can elect under IRC Sec. 83(b) to include all of the value of the stock award in taxable income in the first year. This results in accelerated taxable income, but may result in lower overall tax in the long haul, since gain from that point would be taxed as long-term capital gain (at preferential federal tax rates) when the executive disposes of shares after restrictions have lapsed.
Typically, stock bonus awards (both restricted and unrestricted stock arrangements) are not subject to IRC Sec. 409A rules, as these types of plans currently pay property to the executive, rather than deferring payment to future periods, which is what IRC Sec. 409A generally would pertain to.
For GAAP purposes, the bank records compensation expense on its books in the amount of the fair market value of the stock awarded, in accordance with applicable accounting standards.
A stock option is not stock; it is the grant of a right to purchase stock at a specific price (the “exercise price”) on or after a specified future date subject to specific terms. Thus, stock options do not immediately convey equity ownership to a bank executive, but provide a means of acquiring equity ownership in the future. There are two basic types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs), and the taxation of each varies.
Incentive Stock Options
In order for a stock option plan to be treated as an ISO plan, several exhaustive requirements need to be met. If these requirements are met, an executive does not recognize income when an ISO is exercised (the executive buys the actual stock). Upon the eventual sale of the underlying stock, the executive will recognize a capital gain based on the difference between the sales price and the exercise price. The company receives no deduction in connection with the granting or exercise of ISOs, unless a disqualifying event occurs. In that case, tax treatment defaults to that of a nonqualified stock options.
One potential disadvantage of an ISO arrangement to the bank executive is the alternative minimum tax (AMT) treatment of these arrangements. When the executive exercises an ISO, the difference between the price paid for the stock and the actual fair market value of the stock is treated as an AMT income item. The executive may be hit with an AMT liability, for which the bank gets no tax deduction. The executive may, however, recoup this AMT liability in later years with an AMT tax credit on their personal income tax returns.
Non-Qualified Stock Options
For a typical closely-held financial institution, the granting of NSOs seldom results in immediate recognition of taxable income to the executive because the options will not have a readily ascertainable fair market value. Rather, the executive will generally recognize income equal to the difference between the fair market value of the underlying stock and the exercise price of the options on the date the NSOs are exercised and the underlying stock is not subject to a substantial risk of forfeiture. A substantial risk of forfeiture exists if the options are subject to or dependent on a future event or condition that would result in termination of the NSOs.
The bank recognizes a tax deduction when the executive recognizes ordinary income, generally upon exercise of the NSOs. The bank's deduction is limited to an amount equal to the ordinary income recognized by the executive.
For GAAP purposes, a bank does not record expense at the same rate that deductions are recognized for tax purposes, whether it is an ISO or NSO agreement. Rather, applicable accounting standards requires a bank to record the expense realized by the bank over the service period required by the option agreement. This expense is calculated by determining the stock price versus actual fair market value at the anticipated exercise dates, factoring in market volatility and other factors that may affect the "compensation" portion of a stock option.
For both ISOs and NSOs, banks can typically use a vesting schedule, which limits the number of options that may be exercised until certain dates have passed. This provides motivation for the executive to remain at the bank, and also provides motivation for the executive to provide the leadership needed to increase value of the bank, as their compensation package is now tied directly to bank value.
Careful Consideration Needed
The plans discussed in this article are just the tip of the iceberg—several more alternatives exist for banks to choose from when attracting and retaining their key executives. In determining which plan best fits the bank's situation, bank ownership and executives need to keep in mind the goals and objectives of the bank; whether or not the current ownership group wishes to give up equity in the bank and whether the executive even wishes to receive it; the needs of the executives coming in; and the impact on the bank's earnings and capital, as well the bank's current and future tax situation.
If considering the implementation of a new compensation in order to attract and retain bank executives, always be certain to discuss your alternatives with your legal, tax and accounting advisors before making your decision. Careful consideration and planning can go a long way in making both the executive and the shareholder group happy in the long run.