Seeking an Option on Pay

Some large accounting firms are selling stock plans to charities

Charities have long used car allowances, country-club dues, and other corporate-style perks to attract and retain top executives. But one compensation technique — the stock-option plan — has remained out of place in the charity world.

Until recently, that is.

Relying on a controversial reading of federal tax law, the nation’s big accounting firms are aggressively promoting compensation plans for non-profit executives that are similar to corporate stock-option arrangements in the for-profit world.

Because tax-exempt groups don’t issue stock, non-profit organizations that use the plans offer options on mutual funds, corporate shares, or possibly other assets to executives.

In a typical arrangement, a non-profit hospital or some other tax-exempt employer gives executives the opportunity to acquire shares at an option price that may be significantly less than the shares’ market price. If the shares shoot up in value over time, the executive can reap a significant gain from the options. If the shares drop in price, the executive can simply walk away from the deal and lose nothing.

Proponents defend the strategy as an innovative way to help non-profit groups recruit the best and brightest managers and keep them from seeking lucrative jobs in the for-profit world, where stock options have made many executives fabulously wealthy in recent years.

“The tax-exempt organization is going to have to compete with taxable corporations for talent, and this gives them more flexibility,” said A. Thomas Brisendine, an official of the accounting giant Deloitte & Touche. Mr. Brisendine helped shape his firm’s Key Share Option Plan, or “KeySop.”

Critics say, however, that the option plans pose potential problems for charities. For one thing, they contend, the plans put non-profit groups at risk of violating a new federal law designed to punish people who receive overly generous salaries or benefits through their involvement with non-profit organizations. In addition, they say, the image of stock options as an elite perquisite may turn off donors and invite the scrutiny of charity watchdog groups.

The Internal Revenue Service has yet to declare how it views the stock-option plans. Marc Owens, director of the service’s Exempt Organizations Division, said that the tax rules on stock-compensation plans “have not yet been thoroughly sorted” by the I.R.S.

In the past, Mr. Owens noted, the I.R.S. has approved compensation methods other than simple salary arrangements. But the service still would evaluate individual stock-compensation plans using several criteria, including whether the arrangements met the government’s new salary and benefit standards. In “egregious cases” of abuse, an organization’s tax-exempt status could be in jeopardy, Mr. Owens said.

Accounting executives declined to name any of their clients who offer stock options, citing confidentiality obligations and a reluctance among non-profit groups to publicize their use of the strategy.

Still, accounting executives said the option plans have been considered or adopted by some large non-profit hospitals and educational institutions — places where top medical, scientific, or administrative talent often commands big-league compensation packages. The approach could also gain favor among large social-services charities and other kinds of non-profit groups, compensation experts say.

The option plans, which several big accounting firms have developed as trademarked products, provide guidance to non-profit groups facing traditional government limits on deferred compensation for key employees.

Under Section 457 of the Internal Revenue Code, executives can generally defer taxes on no more than $8,000 of compensation per year, minus any money that goes into a tax-deferred plan, such as a 403(b) or 401(k) retirement account. Deferred compensation above that limit is taxable in the same year that the executive becomes vested — not when he or she withdraws the compensation, as is typical of 401(k) and 403(b) retirement accounts.

The “tax when vested” rule can be costly to an executive, critics of Section 457 say. When taxes are subtracted up front from an employee’s deferred-compensation account, less capital remains to appreciate over time. The reduction can cost the executive thousands of dollars. Not only that, critics say, getting hit with a lump-sum tax bill at the time of vesting can take a huge toll, especially if the executive is in a high tax bracket.

Some non-profit groups delay their executives’ vesting date to forestall taxation on deferred compensation. But that strategy has pitfalls. For instance, if the executive quits the organization before becoming vested, he or she must forfeit the entire sum of unvested deferred compensation.

To find a way around those and other limitations of Section 457 plans, the accounting firms have looked to a different part of the tax code, Section 83, which governs stock options and other property given to employees in connection with services that they perform. While most option plans distribute an employer’s own stock, Section 83 does not prevent organizations from granting options on other assets, such as shares in mutual funds.

Stock options granted under Section 83 usually are not taxed when they are given to an executive, but rather when they are exercised — an event that the executive can delay for years in hopes that the options will increase in value.

What is more, when an executive decides to exercise the options, he or she can do it over several years to avoid incurring a big, one-time tax bill.

And, because non-profit executives may receive options at a significant discount to the shares’ market price — sometimes 50 per cent or more below what the shares would sell for on Wall Street — the potential for making significant profits exists.

Charities carry out their option plans in several ways. Some charities may buy the stock or mutual-fund shares and hold onto them until the executive exercises the option. Buying the shares ahead of time can save the charity money in periods when stock values are rising. Other charities, however, wait until an executive exercises an option before acquiring the shares in the open market. Accounting executives say they discourage charities from using stock from their endowments for the option plans.

Some officials of tax-exempt groups support the stock-option idea as a way to bring salaries in the non-profit and for-profit worlds closer together.

“There is a very strong need in the not-for-profit sector to find ways to legitimately and legally defer compensation, ” said Steven B. Sample, president of the University of Southern California. If the option strategy is a way to do that, Mr. Sample said, “well, terrific.”

But many charity officials are wary of the option idea, partly because they fear that adopting it would cause a backlash from donors.

“It’s not something we would look at,” said Richard Rodrigues, manager of compensation and benefits at Save the Children, an international relief-and-development organization. Financial supporters of Save the Children are sensitive to any spending decisions that may seem excessive or that aren’t focused on the group’s mission, Mr. Rodrigues said.

Perhaps the most compelling reservations about the emerging stock-option strategy concern the legal dimension of such plans. Many critics contend that the plans are in fact deferred-compensation arrangements that should be governed by Section 457 — meaning that the options should be taxed when the executive becomes vested, not when they are exercised.

What’s more, some observers view the option technique as legally risky because of its potential to benefit a select group of charity executives with stock at bargain-basement prices.

Critics also balk at the notion of rewarding executives with stock that is unrelated to the organization they manage. They say a stock-compensation plan should be used only in the for-profit world, where a company can distribute its own stock as an incentive for managers to perform well.

Despite such concerns, the accounting firms vigorously defend the stock-option strategy as a creative and entirely legal way to reward managers. “We stand behind it,” Alan Nadel, a partner at Arthur Andersen, said of his company’s Private Option Plan. “This is not something the I.R.S. could easily dismiss.”

Mr. Nadel and other accounting-firm representatives said they are keenly mindful of the government’s rules against excessive compensation in the non-profit world. A 1996 federal law, often referred to as intermediate sanctions, reinforced the longstanding government policy that people who work for tax-exempt groups should not receive excessive salaries or perks. Charity officials who receive such benefits can now be fined, as can the trustees who approve the benefits.

To meet the requirements of the law, accounting officials said that they try to insure that the size of stock-option grants are not too large in relation to an executive’s overall compensation and that any discounting of share prices is within acceptable bounds. “We have been working with boards and making sure the limits are reasonable,” Mr. Nadel said.

Mr. Brisendine of Deloitte & Touche, a former I.R.S. official responsible for issuing guidance on Section 83 matters, said that whether compensation from a stock-option arrangement meets the I.R.S. guidelines depends in large part on when a value is assigned to the options in the first place.

Mr. Brisendine contends that the options should be valued when they are initially granted to the executive, not when the executive exercises them. Otherwise, the I.R.S. could wind up punishing a non-profit group merely because the stock market — and an executive’s options — did well, he said. The I.R.S. is not likely to hold non-profit groups accountable for the stock-market performance of other long-term benefit plans, such as employees’ 401(k) accounts, Mr. Brisendine argues.

The variety of innovations in executive compensation is likely to increase, analysts say, partly because of the intense competition between the for-profit and non-profit arenas for management expertise. PricewaterhouseCoopers is offering its “Performance Stock Option” plan. Ernst & Young is marketing not only an option plan called “Option It,” which is similar to the plans of the other big accounting firms, but also a compensation strategy for non-profit hospitals in which eligible employees receive “units” of value whose worth is tied to the performance of the institution. As the hospital achieves cost savings, improves its public service, and meets other goals, the units increase in value, much as shares in the for-profit world might do.

Such innovations may gain increased attention. But it is the stock-option deals that could spark the most interest — and scrutiny.

Many compensation specialists are waiting for guidance from the I.R.S. or at least from an impartial law firm before recommending the strategy to their clients.

“There are too many holes in it,” said Hugh Mallon, president of Executive Compensation Concepts, in Baltimore. “It’s not proven yet.”