By connecting an employee’s long-term rewards to the long-term results of the organization, they give incentives for employees to enhance the overall performance of the company (usually two to five years). typically dependent on achieving performance goals and taxed similarly to NQSOs.

LTIPs are often only given to executive-level employees and above, whether the company is private or public, but more and more businesses are beginning to give them to workers who are below the executive level. However, long-term award potential for top staff are roughly 50% lower for private organizations than for public ones due to their liquidity.

How Does an LTIP Work?

An LTIP operates by providing employees (often senior personnel) either cash or business stock in exchange for achieving certain objectives (read more here). The targets are often long-term, lasting three to five years, in order to encourage continuous improvement rather than short-term goals.

In contrast to short-term incentives, LITPs have a retention component built in to entice employees to stick around so they can obtain long-term rewards.

Why Do Businesses Utilize LTIPs?

LTIPs are a deferred pay strategy that benefits both companies and employees in the following ways:

– Pay attention to long-term gains/benefits: While short-term gains are excellent, they can have a price. They frequently compromise consumer connections and are unsustainable. However, over a long period of time, LTIPs can bring your company’s interests into line with those of your employees. In addition to attempting to meet this year’s goals, they are also working to advance the business in order to continue its long-term growth

– Motivate workers to stick with the business. With LTIPs, you can demonstrate your staff the key areas where continuous improvement may be effected, and their long-term compensation holds them responsible for putting that strategy into practice over the following two years.

– Spend less time and money on senior employee hiring. Studies show that when a company replaces a salaried employee, it typically costs six to nine months’ income to educate their replacement. Employee turnover can be a needless drain on your revenues.

These days, this is more of a problem because the average tenure of employees at a company is only two years.

Different LTIP Structures

Nil Cost Options

Participants are first given an option that, to the extent service and performance goals are reached, becomes exercisable at the end of a performance period of at least three years. The normal life of an option is 10 years. Participants can keep the option after it has vested and still enjoy the upside on the gross number of shares covered by the award because no tax is required until the option is exercised. We prefer to use nil cost options in the UK and other countries whenever it is feasible because they have an advantage over the other two ways of structuring LTIPs.

Restricted Stock Units

In the event that service and performance goals are satisfied, participants are given a guarantee or legally binding right to receive free shares at the conclusion of a performance period of at least three years. Usually, participants are subject to taxation upon receiving shares. In the US, for instance, LTIPs must typically be structured as RSUs because there is an upfront tax penalty on the grant of discounted options but not on the award of RSUs.

Restricted Stock

The shares are susceptible to forfeiture upon termination of employment or upon failure to achieve performance goals at the end of a performance period of at least three years, but participants initially obtain beneficial ownership of the shares. UK participants have the option to pay income tax on the value of the shares upon purchase, gaining capital treatment for gains in the future. However, restricted stock is uncommon in the UK because it has a negative impact on cash flow and cannot be recovered if the shares are later forfeited.

Tax Consequences to Employers

Unfunded Plan

Typically, you get a tax break in the year that your contribution is counted toward your employee’s gross income. Typically, this implies that you get the deduction in the year that your employee actually uses the extra benefits under the plan. The complete compensation you pay your employee, including any gains on your contributions, is deductible.

Funded Plan

In general, you get a tax break during the tax year when the portion of your employee’s income that is attributable to your contribution is included. In general, this indicates that you are qualified for the deduction in the year in which you make your plan contributions, or, if later, the date on which your employee gains vested status for the contributions. In general, you are not allowed to deduct any earnings on your funded plan contributions.

When more than one employee participates, you often need to keep separate accounts for each employee in order to be able to deduct your contributions to a funded excess benefit plan.

Additionally, a donation or payment may only be deducted to the extent that it is both reasonable in amount and incurred as an ordinary and necessary expense of operating a trade or business.

Attention: Publicly held corporations are not permitted to deduct for certain executives’ total salary amounts over $1 million in any one year.

Internal Revenue Code Section 409A

The American Jobs Creation Act of 2004 included IRC Section 409A, which provides election, distribution, and funding regulations that apply to NQDC plans, including some excess benefit plans. These guidelines typically apply to deferred compensation after December 31, 2004. (although compensation deferred earlier is also covered in some cases). Participants who are impacted by a plan’s noncompliance with Section 409A’s standards will be taxed on their accrued benefits in the year of the noncompliance (or if later, when those benefits vest).

According to the IRS, Section 409A does not apply to NQDC plans sponsored by employer secular trusts. Excess benefit plans funded by employee secular trusts ought also be excluded from Section 409A as well, although this is not totally apparent, and the Service is expected to provide more clarification. If you have an excess benefit plan in place or are thinking about implementing one, you should speak with a pension expert about how this crucial regulation will be applied to your situation.

Taxation of LTIPs

The type of the award determines how LTIPs are taxed. LTIPs may be taxed in the following ways: 

  • As a bonus paid in shares and subject to employment tax;
  • A share option may qualify for capital treatment depending on whether it is approved (CSOP) or not.

LTIPs are typically implemented by businesses for senior executives whose anticipated awards exceed the permissible maximum of an HMRC-approved share plan.

Owners of businesses are increasingly using employee share ownership trusts to structure sales that are completely free of capital gains tax and approved by HMRC. In situations where there is frequently a crossover with long-term incentive plans, employee benefit trusts may also be established.

Many of the benefits that a seller could get through a third-party sale are also provided by a sale to an employee benefit trust, but there are also additional perks like reduced disturbance and anonymity. The shares can be sold at full market value without the sellers having to pay any Capital Gains Tax (“CGT”), which is a significant tax advantage for the sellers. For assurance, it is feasible to get HMRC’s early approval about the tax implications of the sale of the business.