The Salary Sage

Car Allowances Revisited

In June of 2008, at the height of the recession, fuel prices spiked and a wrote a blog entry on called Car Allowances in the Age of Skyrocketing Fuel Costs. A lot has transpired in the economy, so it seems an opportune time to update that entry.

QUESTION #1 -- What types of costs associated with operating a motor vehicle are reasonably attributable to an outside sales person’s use of a motor vehicle ?

When it comes to answering questions like this, my “go-to” source is the American Automobile Association’s (AAA) annual report on driving costs (“Your Driving Costs”). This highly respected report has been published annually for 51 years and to my knowledge is the most thorough, comprehensive, and reliable information available on the subject of the cost of operating a vehicle in the United States. In it, they consider virtually every cost element including:

• Fuel – Fuel mileage is based on EPA fuel economy ratings weighted 60 percent city and 40 percent highway driving.

• Maintenance — Costs include retail parts and labor for normal, routine maintenance as specified by the vehicle manufacturer. They also include the price of a comprehensive extended warranty with one warranty claim deductible of $100 and other wear-and-tear items that can be expected to require service during five years of operating the vehicle. Sales tax is included where applicable on a national average basis.

• Tires — Costs are based on one set of replacement tires of the same quality, size and rating as those that came with the vehicle. Mounting, balancing, and sales tax are also included.

• Insurance — Based on a full-coverage policy for a married 47-year-old male with a good driving record, living in a small city and commuting three to 10 miles daily to work. The policy includes $100,000/$300,000 coverage limits with a $500 deductible for collision and a $100 deductible for comprehensive coverage.

• License, Registration and Taxes — Costs include all government taxes and fees payable at time of purchase, as well as fees due each year to keep the vehicle licensed and registered. Costs are computed on a national average basis.

• Depreciation — Based on the difference between new-vehicle purchase price and estimated trade-in value at the end of five years.

• Finance Charges — Based on a five-year loan at 6% APR with a 10% down payment. The loan amount includes taxes and the first year’s license fees, both computed on a national average basis.

QUESTION #2 — What is a reasonable rate at which to reimburse the salesperson for the costs they incur in operating their personal motor vehicle for business use?

 An obvious consideration when determining applicable reimbursement rates is vehicle type. Here too, AAA provides useful information, offering data on five different classes of vehicles:

• Small Sedan — Chevrolet Cobalt, Ford Focus, Honda Civic, Nissan Sentra and Toyota Corolla.

• Mid-Size Sedan — Chevrolet Impala, Ford Fusion, Honda Accord, Nissan Altima and Toyota Camry.

• Large Sedan — Buick Lucerne, Chrysler 300, Ford Taurus, Nissan Maxima and Toyota Avalon.

• Sports Utility (SUV) — Chevrolet Traverse, Ford Explorer, Jeep Grand Cherokee, Nissan Pathfinder and Toyota 4Runner.

• Mini-Van — Dodge Grand Caravan, Kia Sedona, Honda Odyssey and Toyota Sienna.

 The table below estimates the total cost of operating all five types of vehicles in California. It includes AAA data adjusted to reflect California differentials versus the national average, and increased usage (i.e., 25,000 miles per year).

DRIVING COSTS

Fuel Cost Summary

YEAR	Avg $/Gal
2006	$2.81
2007	$3.08
2008	$3.51
2009	$2.68
2010	$3.09
2011	$3.84
Overall Average	$3.17

 

 

 

 

 

 

 

 

 

 

 

(1)    Based on $3.17 per gallon which is the weekly average fuel cost in California for regular grade gasoline between January 1, 2006 and July 18, 2011 (as reported by the U.S. Energy Information Administration, a division of the U.S. Department of Energy.)

(2)    The National Association of Insurance Commissioners (NAIC) reports California auto insurance rates are approximately 20% higher than the  national average.

(3)    Represents the amount over AAA's standardized depreciation schedule which is computed at 15,000 miles per year.

(4)   Total cost per year divided by total miles per year

QUESTION #3 -- Is the Internal Revenue Service (IRS) mileage rate a worthy and acceptable measure of the costs associated with operating a personal motor vehicle for business use?

The IRS standard mileage rate used to calculate the deductible costs of operating an automobile for business is 51 cents per mile in 2011. (NOTE: In 2012 this is increasing to 55.5 cents.)This is the amount per mile that the IRS allows small businesses and self-employed persons to use to calculate their vehicle expenses for tax deduction purposes. The standard mileage rate can be used for all mileage accumulated for work-related trips, but “commuting” between home and work does not qualify for this type of deduction. This rate is considered applicable for cars, vans, pickups and panel trucks. IRS has detailed rules for determining when travel between home and business locations should be considered “commuting.” The interpretation of the IRS standards beyond my expertise.

The table below lists the IRS standard mileage rates for the years relevant to this study:

YEAR	IRS Standard Mileage Rate for Business Use of Personal Vehicles (cents/mile)
2006	44.5
2007	48.5
2008 (Jan – Jun)	50.5
2008 (Jul – Dec)	58.5
2009	55.0
2010	50.0
2011	51.0
Overall Average (1)	50.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1) Based on a blended average of 54.5 cents/mile in 2008.

The standard mileage rate for business is based on an annual study of the fixed and variable costs of operating an automobile. The standard mileage rate is determined annually for the IRS by Runzheimer International, an independent contractor, which also performs consulting and other services to many large corporations.

I was unable to locate specific data on how the IRS rate is calculated. What is clear, however, is that it is an average rate that approximates operating expense for all types of vehicles and in all geographic regions, but does not specifically relate to any one type or region. Therefore, it is equally likely to overstate as it is to understate actual operating expenses incurred. Typically, businesses that choose to use the standard mileage rate do so because it is easier to use than the actual costs method (which requires keeping complete and accurate records of all applicable expenses). In my experience, because of the amount of work required to compute the actual cost of vehicle operation, the vast majority of companies elect to use the IRS standard mileage rate to reimburse employees for business use of personal vehicles. I have not encountered any company in my consulting work that reimburses mileage at less than the IRS rate based on any systemic analysis.

CONCLUSION

As the data above demonstrates, the actual cost of vehicle operation varies dramatically based on vehicle type, usage and geography. It appears to me that the IRS rate understates actual operating cost for most mileage and vehicle-type scenarios. In fact, it is not until vehicle usage exceeds 20,000 miles that operating cost falls below 51 cents per mile for all but the smallest and least expensive vehicles.

However, at the 25,000 mile per year level, the IRS rate very nearly approximates actual usage costs for the types of vehicles typically used in sales situations—namely large and mid-size sedans. The actual cost for operating these vehicles at 25,000 per year is between $0.46 and $0.56 per mile making the IRS standard rate of $0.51 a reasonable, and I think realistic, alternative to the onerous task of computing actual operating cost.

The ESOP I Love and the ESOP I Hate (Part 3)

And now, for something completely different. . .

The last two blog entries have dealt exclusively with one type of ESOP, the Employee Stock Option Plan. If you have read those entries, you know that I am not a big fan of such plans. In this third and last installment of the three-part series on ESOPs, we are going to look at an entirely different type of ESOP, the Employee Stock Ownership Plan. What a difference a word can make. This type of ESOP, while not appropriate for every company, can be an enormous benefit when all the right pieces fall into place.

A TRUE WIN/WIN

The term win/win is thrown around rather blithely, but in the case of an ESOP it is really quite accurate. An ESOP simultaneously does all of the following:

1. It provides an exit strategy to owners of privately held businesses by using company profits to fund the sale of the business to the employees.
2. It enables employees to acquire ownership in their company without having to invest their own money.
3. It creates a beneficial relationship between the company and federal and state governments by allowing the Company to use pretax profits to fund the buy-out of the owners.
4. It provides significant tax and retirement benefits to the employees after they become owners.
5. It provides continuing tax advantages for the company after the original owners have sold the business to the employees.

That is the essence of an ESOP. Of course, the devil is in the details and ESOPs are usually highly complex to set up and administer. But beyond the near term financial benefits already mentioned, there are a host of other benefits:

1. Because ESOPs are wholly or partially employee-owned, they tend to have a very unique corporate culture that is built around openness, fairness, and egalitarianism.
2. ESOP companies tend to enjoy unusually high productivity that stems from high levels of employee involvement.
3. ESOP companies tend to place high importance on employee education, participatory decision-making, and open communication.

In general, this makes them a lot of fun to work for.

THERE ARE SOME DISADVANTAGES

As I mentioned earlier, ESOPs are not for everyone, and it is important to consider the downside before taking the plunge. Here are a few things to keep in mind:

1. Availability of Financing -- Fortunate are those companies that are able to finance the sale of the company to employees through cash-flow and associated tax benefits. But most often some form of financing is required. If the transaction is financed with a bank loan, the company must have the ability to qualify for this loan. Otherwise the seller may have to give a personal guarantee and/or self-finance the sale.
2. Disclosure -- ESOPs are required by law to produce a considerable amount of paperwork for the government and the employees.
3. Valuation -- ESOPs must secure an independent valuation each year to establish the value of the stock.
4. Liquidity -- In order to fund transactions as employees leave and/or retire, an appropriate amount of cash must be kept on hand to repurchase their stock. This is not normally a problem for the first few years, but it must be carefully managed after that.
5. Fiduciary Liability -- The plan committee members who administer the plan are deemed to be fiduciaries and can be held liable if they knowingly participate in improper transactions.
6. Stock Performance -- If the value of the business does not increase over time, the employees may feel that they would rather have a cash incentive rather than the deferred benefit provided by an ESOP. In the extreme case, if the company goes out of business, employees stand to lose everything in their ESOP account.

THE BOTTOM LINE

Clearly, the brief and simple description of both types of ESOPs reveals the complex nature of these types of pay plans. To sum it up, I would steer clear of Employee Stock Option Plans in favor of annual cash incentives (provided the cash incentives are self funding and the company can afford them). I encourage owners of privately held businesses who seek an exit strategy to look into Employee Stock Ownership Plans as they provide intriguing possibilities

MORE INFORMATION

Check these links for more information on Employee Stock Ownership Plans:

Menke & Associates -- Consulting firm specializing in setting up and administering ESOPs

National Center for Employee Ownership -- National association made up primarily of ESOP organizations

Great Game of Business -- Organization dedicated to disseminating the principles of employee ownership

The ESOP I Love and the ESOP I Hate (Part 2)

In Part 1 of this three-part series on ESOPS, I expressed concern that the combination of economic uncertainty, cost-cutting measures, and unwarranted vilification of cash incentives might result in an upsurge in Employee Stock Option Plans (ESOPS). In that posting, I described my concern in terms of the following objections:

• The volatility of share price
• Minimal employee impact or control over this price
• The artificial illusion of extreme value fostered by granting large numbers of low-value shares
• Managers creating unrealistic expectation of the future value of options
• Excessive complexity and administrative expense
• The huge distraction (even obsession) caused by such programs
• The tendency for options to create more selfishness (and jealousy) than teamwork

But this is only the tip of the ice-berg. The effectiveness of any compensation program is directly related to how well employees understand it. Since stock options are among the most complex compensation vehicles around, a major communication and education effort is essential in order to avoid confusion and dissatisfaction. This is particularly important with options because unlike other forms of compensation, there is a long list of gotchas than can creep up to bite employees in the backside and shatter their expectations. Below is a list of some of these things:

VESTING SCHEDULES

Stock options are rarely owned by employees when they are granted. Instead, the employee "vests" or qualifies for their options over time based on some schedule. These schedules often require employees to wait 4 or 5 years before they actually own the options granted to them when they join the company.

DILUTION

Dilution occurs when investors put money into the company and receive stock in return. This has the immediate effect of reducing the value (not the number) of everyone else's shares.

REVERSE SPLITS

When companies go public, it is not uncommon for them to declare a reverse split. This is an instantaneous reduction in the number of shares owned by all employees. One of my clients had been telling employees for months that their stock would be valued around $12 per share when it went public. They neglected, however, to mention that this was after a 10:1 reverse split (they argued that such information would demotivate the employees so they conveniently suppressed it). So while it is true that the stock did come out around $12 per share, every employee lost 90% of their shares, effectively making their stock worth $1.20 per share, not the $12 they were promised.

BUY-OUT CLAUSES

Some stock plans involve buy-out clauses that enable management to buy-back employee shares at any time at the fair market value that exists when the buy-back occurs. I once owned a 5% share in a Company that was rapidly increasing in value. When management saw that the company would be worth a fortune in a few years, they activated the buy-out clause, paying me a small amount for shares that three years later were worth a fortune.

PREFERRED STOCK

Stock options are granted as common stock. But some companies also issue preferred stock (usually to investors) with considerably greater privileges and hence value. Since preferred stock gets paid out first, there are many instances where the holders of common stock (i.e., the employees) end up with nothing.

EXPIRATION

Stock options normally have expiration dates. It is possible for employees to wait 5 years for shares to fully vest then have them expire before they are worth anything.

LITIGATION

Not surprisingly, with such complexity, uncertainty, confusion, and greed, stock options are ripe for litigation. This is a great boon to lawyers, but a source of enormous frustration, delays and ultimately disappointment for employees.

VALUATION

Before a company is publicly-traded, the value of stock options must be determined through an independent valuation. This amounts to a complex financial analysis followed by a judgment call on the part of a valuation professional. Such professionals value companies based on a number of different variables, but the most important one is profitability. Unfortunately, profitability can be easily manipulated by those with a controlling interest. I have one client whose company profit is severely impacted by the owner's lifestyle, much of which is charged to the business (corporate jet, country retreat, expensive meetings in exotic places). By the time all this is over, there isn't much profit and the value of the business is adversely impacted.

THE BOTTOM LINE

Whenever I am advising business owners about whether or not to create a stock option plan, I usually suggest they keep their equity and find other ways to motivate employees. Whenever I am advising employees about whether or not to accept a job involving a significant cut in pay in return for stock options, I usually suggest that they negotiate for more cash or look for another job. At the end of the day, stock options don't do the company or its employees any favors. Both are better off making effective use of incentives which are far better at driving results. They also pay employees in something they can count on, cash.

In the next entry of this three part series, I will take a look at the type of ESOP I really like, the Employee Stock Ownership Plan.

The ESOP I Love and the ESOP I Hate (Part 1)

Unless I miss my guess, ESOPs are going to make a comeback soon. Just as toadstools sprout from the mud after a steady rain, ESOPs surge after economic slowdowns. What are ESOPs? That depends on whom you ask. There are actually two distinct types, a fact that leads to considerable confusion. This confusion is enhanced by the fact that both types are very complicated. And now we know, if we know nothing else, that complicated financial instruments can lead to big problems. Fortunately, with ESOPs, these two types are radically different, one in my view to be avoided at all cost, and the other extremely beneficial (although not overly common).

THE TOADSTOOL

The toadstool that I referred two is one of the two types of ESOPs -- namely, the Employee Stock Option Plan. These are the programs whereby employees are granted the option to purchase shares in their company at a discounted price ("strike price") and can redeem them later for a payout if the value increases.  As a rule, employees pay nothing for these shares when they are granted, then after some period of time when the value of the shares have increased, the employee sells them and realizes the gain associated with the difference between the strike price and the market value at the time of the sale. The intent is to align employee interests with those of the shareholders by providing employees with motivation the behave in ways that will boost the company's stock price.

The reasons that I consider this type of ESOP to be a toadstool are almost too numerous to list, but I will attempt to do so, beginning with the one that relates to their popularity in financial downturns. ESOPs are viewed by companies as a way to compensate employees without spending real cash. And real cash is something companies don't have much of right now. This is why I am anticipatinga surge in ESOPs. I suspect employees may start to hear their leaders say "we can't pay you back the money you lost in recent salary cuts, so we are going to issue options." If this happens, a lot of people are going to experience the downside of options. So what are those downsides?

• First of all, let's face it, the value of a share of stock has about as much connection to the value of a business as a bet at the crap table has with a passbook savings account. So the inference that employees who own stock will be better employees is about as sensible as saying that gambling helps you save money. Sensible action on the part of employees rarely has any connection whatsoever to share price. So rather than encouraging right action, stock options create an intense fixation on something completely outside employees' control.
• In addition, by their nature, stock options create the illusion of extreme value. Sensible people who would never expect their salaries to double over-night, naturally assume their shares will. Ask anyone who owns a pile of stock options valued at $1 per share what those shares will be worth in three years and you will be shocked at what you hear. For every person who says 50 cents, there will be 100 who will say $20. And where do they get this idea? Often not from themselves. They get it from management.
• Stock options are the perfect vehicle for managers to create (consciously or unconsciously) the illusion of future wealth for their employees. This illusion can be used to great advantage to secure increased loyalty and extra effort. If employees can be convinced that their options will make them wealthy, they will attempt to move mountains.
• To encourage this perception, companies grant huge sums of stock. They do this in order to make the grants appear more valuable than they actually are. Case in point -- rather than giving an employee 1 share of stock valued at $5,000, they will grant 50,000 shares wort 10 cents. By doing this, they are manipulating human nature. They know that a person can more easily be imagine a 10 cent investment becoming worth $10 than they can imagining a single $5,000 share suddenly being worth a half million dollars. But the ratios are the same.
• What happens when reality settles in (as it always does) and stock options fail to live up to employees' expectations? Disappointment, resentment and betrayal are sure to follow.
• The reality of options is that real wealth, as in so many other things, if it is to be had at all, falls into the hands of a select few (usually high level executives and investors) not the larger employee group.

All of this, coupled with the fact that administering a company-wide ESOP program is breathtakingly expensive and complicated makes it, in my view, one of the most flawed forms of compensation ever conceived. In fact, of all the companies and people I have known involved in ESOPs (and there have been hundreds), the only person I know who consistently sings their praises has spent his entire career at Exxon. Over the last 30 years his stock has steadily increased in value and has made him a wealthy man. But for every person like that, there are thousands who worked for companies like Enron and AIG who have a very different story to tell.

THE BOTTOM LINE

If you find yourself talking to a company about a new job, and management starts discussing stock in lieu of cash, beware. Your pocket is about to be picked.

In the next entry of this three part series, I will provide additional details on more pitfalls and problems with Employee Stock Option Plans.

Non-Cash Incentives -- Do They Work?

Every now and then I run across a client who is interested in learning more about non-cash incentives. These are non-monetary awards that go out to individuals in lieu of cash, either for certain predetermined outcomes or as an after-the-fact bonus for a job well done. On the surface, such programs appear very attractive and I used to be a big fan of them. They can really add spice to an otherwise dull and boring pay program, and in many cases are far less expensive than cash payouts. For someone making $90k per year, a $2,500 cash payment might not be all that exciting, but a couple can go on a pretty nice trip for far less and have a really good time -- especially if they can treat themselves to a guilty pleasure that they would never afford on their own (like a spa weekend with all the trimmings).

Over the years, however, I started to take stock of these programs and noticed some rather disturbing trends. Surprisingly, they weren't nearly as popular or well-received as I expected. In fact, people groused about them a fair amount. Here are the difficulties I observed:

• It is difficult to conceive of a single trip that will motivate everyone. For example, I would really get excited about an adventure travel experience in Antarctica, but I would have no interest in a gambling trip to Las Vegas. My wife, on the other hand, is exactly the opposite.
• Let’s face it, there are a lot of people who simply don’t like to socialize with colleagues from work and this, in and of itself, is enough to stunt their interest.
• People with small children can have real issues at home when one spouse goes off on a fun-filled extravaganza and the other is left home to deal with the screaming kids.
• If spouses are allowed to come, then to be fair significant others (boyfriends, girlfriends, same sex friends, gay lovers, you name it) should also be included. If spouses aren't invited then you get the issue I just mentioned.
• Trips can be notoriously unreliable when it comes to the quality of the experience. Even the best resorts can have weather problems, construction issues, service issues, not to mention travel delays, etc. Travel today is very hit and miss and a poor experience can ruin everything.
• There are many stories about the embarrassing (even humiliating) things that happen on company outings. Drunken outbursts, extra-marital affairs, sobbing on ropes courses, can haunt a work-group for years. They do, of course, make great stories that never seem to get old in the re-telling.
• People’s lives are complex, and things happen. Employees get sick, relatives get sick, there are birthdays, anniversaries, graduations, etc. and if someone works all year to qualify for a trip that conflicts with some important expected or unexpected event, they are out of luck.
• Trips are very complicated to plan and pull off. Some of my bigger clients used to have whole departments dedicated to planning and executing them.
• The value of the trip needs to be imputed as pay and the participants (or the company on their behalf) must pay taxes on the value they receive. This can be a huge mess.

THE PERFECT PAY PLAN

That pretty much takes care of trips, but what about other non-cash options? I really like the idea of a manager having at his or her disposal a stack of sports or theater tickets, restaurant vouchers, gift cards, travel vouchers, massage certificates. and handing them out on the spot when a person does something wonderful. I have seen this work extremely well and have used it myself to great effect. But when it comes to making non-cash rewards part of a formal compensation program in lieu of cash, I think that is a bad idea. At the end of the day, cash really is king, and people prefer to receive their rewards in a form of common currency that allows them to decide what they do with it -- even if that means paying off a some stubborn debt which isn't such a bad idea either.