Industry Update
Opinion Article19 February 2007

Effective Long-Term Incentive Plan Design within the Chain Restaurant Industry

By David Mansbach

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Mansbach

When it comes to the design of executive level long-term incentive plans within the chain restaurant industry I have found that many companies are losing out on a great opportunity to align rewards with company objectives. In this article I will address common flaws and provide solutions for your organization to consider.

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The foundation to a successful long-term incentive plan is to constantly review the objectives of the organization. A diligent and consistent analysis of key tenants such as the company mission and vision statement, core values, culture and ever changing business environments will enable you to be in an ideal position when implementing or revising the long-term incentive program.

Once stated objectives are understood your organization can align strategies with the appropriate long-term incentive program. A common mistake I have seen is when companies implement a "safe" decision and stick to what is already in place or "mirror" what their competitors are doing. Listed below are sample objectives linked with the appropriate plan options.

A restaurant company that needs to attract key executives should consider incentive stock options (ISO)

Incentive Stock Option – A stock option that qualifies for favorable tax treatment (no tax at exercise and long-term capital gains treatment if shares are held for one year after exercise and two years after grant before sale) that meets other rules as specified by legislation. The applicable section of the Internal Revenue Code (IRC) is Section 422

A restaurant company that needs to attract executives while providing employer tax benefits should consider nonqualified stock options (NQSO)

Nonqualified Stock Option – Stock options that do not meet IRS requirements to qualify as ISOs. These options tend to be more flexible in terms of plan design, and consequently are more prevalent than ISOs. “Nonqualified” refers to the inability of the plan to qualify for preferential tax treatment under the Internal Revenue Code

A restaurant company focusing in on the retention of key employees should consider restricted stock

Restricted Stock – Stock that is given (or sold at a discount) to an employee, who is restricted from selling or transferring it for a specified time period (usually three to five years). The executive receives dividends, but must forfeit the stock if he/she terminates employment before the restriction period ends. If the employee remains in the employ of the company through the restricted period, the shares vest, irrespective of employee or company performance

A restaurant company desiring immediate employer tax deductions and long-term employee ownership should consider a defined contribution plan (DC).

Defined Contribution/Pension Plan – Defined by the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC) as a plan that provides for future income from an individual account for each participant with benefits based solely on 1) the amount contributed to the participant’s account plus 2) any income, expenses, gains, losses and forfeitures of accounts of other participants that may be allocated to the participant’s account. The benefit amount to be received by the participant at retirement is unknown until retirement

Whether your organization implements one of the long-term incentive plans listed above or other programs such as Phantom Stock or an Employee Stock Purchase Plan (ESSP) it should be noted that the tax impact can vary greatly. Employee and employer tax implications should be analyzed to ensure the plan makes sense. Listed below is a succinct chart created by WorldatWork, the world's leading not-for-profit professional association dedicated to knowledge leadership in compensation, benefits and total rewards, which addresses long-term incentive reward programs, key provisions, tax impact to the employee/employer and earnings impact to the organization.

Comparison of Equity-Based Reward Programs

Tax Impact Earnings Impact
Program Key Provisions Employee Employer FAS 123(R)
ISOs Qualified stock options/design restrictions No tax until sale (assuming holding period requirements met) At sale - capital gains on appreciation from grant price No tax deduction unless holding requirements not met Grant date fair value charged to earnings over service (vesting) period
NQSOs Nonqualifled stock options/design flexibility At exercise - ordinary income on the spread between the grant price and FMV at exercise At sale - capital gains on appreciation after exercise At exercise - tax deduction equal to ordinary income recognized by executive Grant date fair value charged to earnings over service (vesting) period
Performance Shares Employee earns portion of multiple of shares, paid in cash or stock, if targets are met. At grant - no tax At payment - ordinary income At grant - no deduction At payment - deduction equal to ordinary income recognized by executive Stock-settled - Grant date fair value charged to earnings over service (vesting) period Cash-settled - Variable charge to earnings over service (vesting) period
Restricted Stock Awards Whole value shares to employee/restrictions encourage retention At grant - no tax [unless 83(b) election made] As restrictions lapse - ordinary income Dividends taxed as ordinary income until restrictions lapse Tax deduction at the same time and in the same amount as ordinary income recognized by executive Grant date fair value charged to earnings over service (vesting) period
SARs (settled in cash) Granted standalone or in tandem with stock options. Payment in cash equal to stock's market value at exercise over the option price. Same as performance shares; subject to IRC Section 409A if granted at less than FMV Same as performance shares Variable charge to earnings over service period
SARs (settled in stock) Granted standalone or in tandem with stock options. Payment in stock equal to stock's market value at exercise over the option price. Same as performance shares; subject to IRC Section 409A if granted at less than FMV Same as performance shares Fair value fixed at grant and recognized over service (vesting) period
Phantom Stock Employee receives appreciation in book, formula or FMV of shares over a set time period. Paid in cash or stock. At grant - no tax At payment - ordinary income on appreciation; may be subject to IRC Section 409A At grant - no deduction At payment - tax deduction equal to ordinary income recognized by executive Appreciation charged to earnings quarterly
Performance Units Employee earns a fixed number of units, paid in cash or stock, based on the achievement of performance goals. Same as performance shares Same as performance shares Value of units charged to earnings to the degree that goals have been achieved over the performance period
ESPP Qualified or nonqualified plan where employees buy shares, often at a discount off FMV At sale - possible ordinary income on bargain element, capital gains on remainder Tax deduction only if employees recognize ordinary income Charge to earnings on any discount
ESOP Qualified DC plan. Majority of shares in company stock At distribution - ordinary income At payment - Contributions to fund ESOP and dividends paid on ESOP are deductible
401(k) Qualified DC plan. Employer match may be in company stock. No more than 10% of employee elective deferrals in company stock. At distribution - ordinary income At contribution - tax deduction on contribution.
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