By Brennan P. Connor
Attracting and retaining quality employees is a concern of all businesses but, in today’s economy, is of particular importance in the construction industry. According to a recent press release from the U.S. Chamber of Commerce, more than half (52 percent) of contractors say they will hire more employees in the next six months, up from 46 percent in Q1 2021. However, according to the same press release, 88 percent of contractors surveyed stated they are currently having moderate to high levels of difficulty finding skilled workers.
One way contractors and construction business owners can attract potential employees and retain existing employees is to adopt an employee incentive plan. Awards made under an employee incentive plan can provide employees with additional income and/or equity ownership, motivate employees by tying such awards to the employer’s financial results and incentivize employees to remain with their employer until such awards vest and are paid out.
Before designing and adopting an employee incentive plan, employers need to consider the related legal and tax implications, particularly when awards under an employee incentive plan are considered “deferred compensation” by the Internal Revenue Service. Below is a summary of different types of employee incentive plans and a high-level overview of the tax considerations when adopting a plan that features awards of deferred compensation.
Overview of Different Types of Employee Incentives
There are a wide variety of employee incentives that employers can consider when designing and adopting an employee incentive plan. Popular employee incentives include, but are not limited to, the following:
- Phantom Stock – an unfunded, unsecured promise to pay the value of stock in cash, in the future. This is designed to replicate company stock without giving away actual stock.
- Stock options – a right to purchase stock at a set price.
- Stock appreciation rights – a right to receive the excess of the fair market value of granted stock over the exercise price for such stock.
- Cash bonus – additional cash compensation which is generally tied to achievement of certain financial metrics by the employer and/or the employee.
Employee incentive plans may – and typically do – provide that awards granted under the plan shall vest over a period of time and then be paid out at a later date or upon the occurrence of certain events, such as retirement, change in ownership of the employer and others. In other words, the award is earned in one taxable year and then vests or is paid out in a later taxable year or years as deferred compensation.
If an individual’s employment terminates before his/her award vests or is paid out, the award is generally forfeited. Accordingly, employees receiving awards of deferred compensation have an incentive to remain with their employers until their award vests or is paid out. Employers should be aware, however, of important tax considerations which arise when granting awards of deferred compensation. One of these tax considerations involves the requirements of Section 409 of the Internal Revenue Code.
Internal Revenue Code Section 409A governs all awards of deferred compensation and imposes penalties on employees and employers for noncompliance. While a detailed breakdown of all the requirements of Section 409A is beyond the scope of this article, employers should be aware that to be compliant with Section 409A, an award of deferred compensation:
- Must be made pursuant to a written plan.
- The plan must specify the form of distribution of the award, such as lump sum or installments.
- The award may only be paid out upon the occurrence of certain events, such as: an employee’s separation from service, disability or death; a fixed time or schedule; a change in control of the company’s ownership or a substantial portion of its assets; or an unforeseeable emergency.
- The award may not be accelerated/paid early, except in highly specific circumstances.
Noncompliance with 409A results in the employee being subject to income tax in the year the deferred compensation award becomes vested, regardless of when deferred compensation is scheduled to be paid. An additional 20 percent excise tax is also imposed on the employee plus any applicable penalties and interest, while the employer may be subject to penalties and interest for failing to timely report and withhold taxes for a noncompliant deferred compensation award.
While deferred compensation awards can help contractors and construction companies attract and retain employees, employers must take the requirements of Section 409A into account when designing and implementing an employee incentive plan to avoid unintended and adverse tax consequences.
Brennan P. Connor is an attorney at Carmody MacDonald in St. Louis. He focuses his practice in the areas of taxation, business law, estate planning, and real estate. He can be reached at firstname.lastname@example.org or 314-854-8706.
This column is for informational purposes only. Nothing herein should be treated as legal advice or as creating an attorney-client relationship. The choice of a lawyer is an important decision and should not be based solely on advertisements.