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Equity-Based Compensation Attracts and Retains Top Talent

October 03, 2023

Many employers continue to struggle with recruiting and retaining top employees in the tight labor market. Some have turned to equity-based compensation to lure new talent and retain existing employees.

If you’re not currently offering equity-based compensation, now might be the time to reconsider. In a 2022 report from Morgan Stanley, 85% of business leaders surveyed reported that equity was an important component of their overall compensation strategy — and 80% expected the importance of such compensation programs to increase over the next five years. Equity-based compensation offers a range of benefits to both employers and employees.

Perks of Equity-Based Compensation

When a candidate is deciding among multiple job offers, the prospect of equity-based compensation can tip the scales in their favor. But that’s only one of the advantages.

Employees with equity-based compensation have more skin in the game. It aligns the interests of the employee with those of the employer. This often leads to higher levels of motivation, engagement, loyalty and, ultimately, productivity. In other words, it can boost your bottom line, while also improving employee morale and enriching company culture.

Moreover, equity-based compensation doesn’t require the same upfront investment from employers as, for example, generous hiring bonuses. This factor can help level the recruitment playing field for employers that don’t have substantial cash on hand.

And, of course, employers can deduct qualifying equity-based compensation from their federal taxable income. (Note that the timing of deductions varies by the type of equity-based compensation. Consult our Tax Services Group for more information.)

Common Types of Equity

According to the IRS, equity-based compensation is any compensation paid to an employee, director or independent contractor that’s based on the value of the specified stock (typically the employer’s stock). Employers that decide to offer equity-based compensation have several options, each of with comes with different tax rules, as well as pros and cons.

Some of the most common types of equity-based compensation include:

Stock options. With stock options, employees generally receive the right to purchase a specified number of shares at a fixed “exercise price” for a predetermined period, usually subject to a vesting period. The IRS recognizes two versions — incentive stock options (ISOs) and nonqualified stock options. The latter offer greater flexibility because ISOs are subject to stricter IRS requirements.

Restricted stock awards (RSAs). RSAs are granted to an employee on a grant date, but the employee’s rights in the shares are restricted until they vest (assuming the employee is still with the company). They can be preferable to stock options in circumstances where the stock price has dropped below the option price.

Restricted stock units (RSUs). RSUs are similar to RSAs, but the shares aren’t transferred to the employee on the grant date. Rather, RSUs are a promise from the employer to deliver shares in the future, at which time the employee becomes a shareholder. The employee generally must meet certain conditions before the shares are delivered (for example, performance milestones or a specific tenure with the employer).

Stock appreciation rights (SARs). SARs give an employee the right to a future payment based on the appreciation in the value of a specified number of shares over a predetermined period. As with stock options, the value increases as the stock price rises, but, in contrast, employees don’t have to pay an exercise price to benefit.

Phantom Stock Plans. Phantom stock, sometimes called shadow stock, grants chosen employees (senior management) numerous advantages resembling stock ownership (without providing them with any actual company shares). This can apply to a limited liability corporation (LLC), a sole proprietor or S-companies/Phantom stock ties a financial gain directly to a company performance metric.

Getting Started

Launching an equity-based compensation program requires much forethought and planning. Among other things, you’ll need to research your competitors’ offerings, set vesting periods and eligibility criteria, and develop the requisite accounting processes and procedures.

The IRS keeps a close eye on equity-based compensation. Employers should bring in professional help sooner rather than later to reduce the risk of running into tax compliance issues. Contact our Executive Search Group for help designing, developing and implementing compensation programs that attract, motivate and retain skilled workers.

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