Page 419 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 405

As for taxation, the basic rule still applies. Namely, compensation is taxed as ordinary
income when received and the company has a like-amount tax deduction in that same year.
However, there are two basic exceptions: exercise gain on statutory stock options and long-
term capital gains (when stock has been held for the required length of time). There is neither
income recognition nor a company tax deduction on the difference between grant price and
fair market value at time of the exercise of a statutory stock option. Considerable time will be
spent reviewing this feature later in the chapter. However, such gains are considered tax
preference income and are taken into account when calculating an alternative minimum tax.
Secondly, companies receive no tax deduction on income gains to the executive taxed as long
term. This will also be reviewed in detail later in the chapter.
The Internal Revenue Code (IRC) not only requires shareholder approval of statutory
stock option plans, but also requires shareholder approval of long-term incentive plans affect-
ing the CEO and other four named executives in the proxy to avoid the limit of a $1 million
compensation tax deduction on total pay for each. This is detailed in Section 162(m) of the
IRC and was discussed in Chapter 4.
The Securities and Exchange Commission (SEC) defines insiders (those with informa-
tion not available to the public that could affect the price of the stock), conditions under
which they may buy and sell company stock, and what reports they must make regarding
purchases, sales, and holdings. Additionally, the SEC details the manner in which long-term
incentive plans must be reported for the five named executives in the proxy.
The reader is again reminded not to rely on accounting, tax, or SEC statements in this
chapter. One needs to seek appropriate professional counsel for such guidance. Statements
made in this chapter and elsewhere are offered as being illustrative to help frame such
further investigations by the reader with appropriate counsel.

PLAN TYPES

Like their short-term cousins, long-term incentives are either dependent upon stock price
(market-based) or independent of stock price (nonmarket-based). This chapter will deal with
both types of plans. However, due to their nature, there are considerably more variations
within each category than can be described in detail within the confines of this chapter.
Nonetheless, the chapter should provide sufficient detail to enable the reader to create his or
her own program. We begin with market-based plans.

PUBLICLY TRADED STOCK PLANS

Market-based plans typically use common stock, which is traded on one or more stock
exchanges. Plans either deal with an option to buy or an outright grant of stock (thereby
requiring no financing by the executive). The stock may be received either in the form of
actual stock certificates or credited electronically to an account in the executive’s name. This
is sometimes called a book-entry form.
There are three ways to acquire an interest in stock: buy it, receive the appreciation in
the stock price, or be given the stock. There are two ways in which to buy the stock: through
a stock purchase plan or a stock option plan. We begin this section by reviewing the most
popular form of market-based plans, the stock option.