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Wealth Planning Insights


Bonus Season

Planning to Optimize your Rewards

> Download Bonus Season [PDF]

Bonus season 2015 promises to be a rewarding one for many executives. Employers increasingly are using bonuses and incentive plans as an integral and flexible component of executive compensation. This trend, paired with the rebounding of many sectors of the economy, has led to one of the most robust allocations to bonus and incentive compensation by employers in recent years.

Executives make a significant investment of their time and talent in the work that fuels the performance underlying bonus and incentive compensation. However, it is not uncommon for the executive, whose strategic and visionary work resulted in a bonus to dedicate little of their time and attention to personal finances, including bonus and incentive compensation planning. In the early years of one’s career a bonus may be spent before it is received. Later in one’s career, competing demands on an executive’s attention may lead to benign neglect, the cumulative effect of which can be significant over a period of years.

Planning for bonus and incentive compensation can accelerate the realization of financial goals – retiring debt, funding education for children and grandchildren, achieving a sufficient level of retirement savings, making family and philanthropic gifts. The key is to make a plan and then execute on it – simple to say, but harder to accomplish. Not surprisingly, executives experience a wide range of success in their individual planning. Key elements for successful bonus and incentive planning include identifying goals and putting them in writing, communicating those goals to a spouse, partner or close confidant (old fashioned accountability) and working with a trusted advisor – someone who will offer planning solutions tailored to your goals.

In this Wealth Planning Insights we provide an overview of some bonus and incentive compensation planning considerations. However, bonus and incentive compensation plans vary from company to company and individual planning is just that – individual. Conferring with your financial, tax, legal and investment advisors to determine your individual course of action is recommended.

Bonus and incentive compensation takes many forms, and each has differing degrees of complexity. The simplest and most common is the cash bonus. Restricted stock is another component of many bonus and incentive packages. Stock options round out our discussion of incentive compensation arrangements, and the related planning can be complex. No matter what form your bonus and incentive compensation takes, bonus season is an opportune time to review your financial circumstances and update your personal balance sheet.

Cash bonuses offer a great deal of planning flexibility for the executive. A cash bonus can be applied to any one of a range of financial objectives. Early on, debt reduction is a common priority – consumer debt and mortgage debt. If being debt free is a financial goal, using your bonus for an extra mortgage payment can shave years off your amortization schedule.

Cash bonuses are also a ready resource for funding an emergency reserve, or increasing that reserve as lifestyle expenses increase over the years. Common wisdom is to set aside three to six months of expenses in an emergency reserve. Those who were dislocated during the Great Recession of the not too distant past, or are familiar with peers who were, have a real sense of just how long it can take to get back on track in one’s career and financial circumstances, and how beneficial having an emergency fund can be.

Education funding is another area to consider when determining how to deploy a cash bonus, particularly given the increases in education expenses in recent years. There are a number of approaches to education funding. For example, 529 plans can be funded gift tax-free with up to five years’ of annual exclusion gifts ($14,000 per donor per donee in 2015, with gift-splitting available for married couples). In 2015, this allows for funding of $140,000 in a 529 plan in a single year by a married couple. The peace of mind that funding education provides for many parents and grandparents makes education funding a particularly rewarding allocation of a cash bonus.

Family and charitable gifting may also be considered. Cash is ideal for making annual exclusion gifts to family members, either outright or in trust. Making annual exclusion gifts early in the year around bonus time allows for a longer time of growth for the recipient, particularly where a gift is made in trust, and can eliminate some of the year-end haste around making gifts before the calendar turns and the annual exclusion gift amount for the current year expires.

For those who choose to give to charity, a cash bonus is often a tax efficient source of gifting. Cash bonuses are compensation subject to income taxation and some of the tax bite can be offset with a gift to charity in the same tax year. Charitable gifts are subject to various limitations for income tax purposes. But cash gifts enjoy higher deduction ceilings than non-cash gifts – 50% of adjusted gross income for gifts of cash to public charities, with a five-year carryover of any excess, subject to applicable itemized deduction phase-outs.

A cash bonus is an ideal resource for investment – either in a lump sum or under a more structured incremental regime over the course of the year. The consistent investment of a portion of your bonus over a period of years will ordinarily lead to greater accumulations for retirement and other longer-term goals.

Finally, cash bonuses are a source of funding for personal rewards – a vacation, a special gift for the spouse or partner who supports you in your work, or that new car you’ve been waiting for. But the real gift to self, to family and to community is in having a plan and executing on it diligently.

Stock-related bonus and incentive compensation offers planning opportunities that can lead to substantial wealth accumulation and prudent management will enhance the outcome even further. The two most common categories are restricted stock and stock options.

Restricted Stock
Restricted stock grants are the easiest to understand and manage. That being said, awareness of the nuances can help capture planning opportunities which may have been missed otherwise, or at a minimum, ensure decisions are fully informed.

A restricted stock award is a grant of stock by an employer to an employee subject to specified limitations during a defined time period. The stock “vests” when the limitations lapse or expire. Although an award of restricted stock by an employer for past services is income to the employee, when and how it is taxed varies, and the employee has some choices. Absent what is referred to as a “Code Section 83(b) election” (discussed below), the income associated with a grant of restricted stock is deferred until your rights in the stock vest. When the restrictions expire and the stock vests, the fair market value of the stock at the time of vesting is include in your income and taxed as ordinary income in that year. If you later sell the stock, any gain (or loss) will be capital gain (or loss), either short term or long term, with the vesting date considered the acquisition date.

Alternatively, you may choose to recognize ordinary income in the year the stock award is granted by making a Code Section 83(b) election. The election is required to be made within 30 days of the grant of the stock and the amount of ordinary income is determined based on the fair market value of the stock when the grant is made. If you make an election, although you will have ordinary income in the year of the grant, you won’t be taxed on any appreciation in the value of the stock until you sell the stock (i.e., there is no further tax when the stock vests), and any appreciation will be taxed as capital gain.

If you have cash available to pay tax currently and are confident your company stock will appreciate following the grant, the Code Section 83(b) election allows for the tax on any appreciation after the election to be deferred until the stock is sold, and then to be taxed at lower capital gain tax rates if the stock is held long term. However, if you elect to pay ordinary income tax on the grant price in the year of the grant, the risk is paying too much tax if the stock declines in value between the time of the grant and vesting. And if the stock is later forfeited because any applicable restrictions are not satisfied (such as continued employment), you are not entitled to a deduction or refund of the tax paid in the year of the grant, although you may be able to claim a capital loss with respect to the stock.

Example: Employee receives a grant of 1,000 shares of restricted stock in 2015 conditioned on continued employment with the company, the stock vests in 2018, and he sells the stock in 2020. The value of the stock at the time of the grant in 2015 is $75 per share, the value of the stock at the time of vesting in 2018 is $100 per share, and the value of the stock at the time of sale in 2020 is $125 per share.

As time passes, many executives who receive restricted stock awards accumulate holdings in their company stock which are a significant portion of their assets; this can be intentional or through inertia. It is advisable to be cognizant of both the risks and rewards of single stock concentrations and determine the desired level of diversification. In situations where you are able and willing to sell some of your company stock, vesting may be an opportune time to do so. If vesting and sale occur simultaneously and no Code Section 83(b) election was made, the ordinary income tax triggered by the vesting will be due, but there will be no additional gain to tax, and you will have cash to deploy.

Performance shares are a variation of restricted stock becoming more common at the upper echelon of executive compensation plans. A “target” share award is set at the grant date, with actual results determined by corporate or business unit performance metrics over the valuation period. The final number of shares received is adjusted by the performance factor, and could range from zero to 2x the target share award.

Stock Options
Stock options are another form of incentive compensation, but have a different economic outcome from restricted stock. Employee stock options provide the holder with a right to purchase shares of company stock at a pre-determined price (the strike price) for a period of time, subject to a vesting schedule. The tax treatment depends on whether the option is a qualified incentive stock option (ISO) or a non-qualified stock option. The relevant points in time from a tax planning perspective are when the option is granted to the employee by the employer, the exercise of the option by the employee to acquire the underlying stock, and the disposition of the stock acquired upon the exercise of the option. The amount of appreciation achieved above the strike price (the spread) can allow for exponential value creation, but stock options can be worth zero if the stock declines and never exceeds the strike price.

Incentive Stock Options
Common in start-ups, incentive stock options carry some unique features, and require thoughtful management to avoid unpleasant surprises, primarily due to the alternative minimum tax (AMT). A number of technology employees were blindsided by tax obligations following the bursting of the “tech bubble” in the early 2000s. Favorable taxation is available with incentive stock options if carefully managed, but navigating the intricacies between regular income tax and AMT requires both liquidity planning and tax planning with your individual tax advisors. The discussion below is only an overview of a complex topic.

There are a number of qualifications to satisfy for a stock option to be treated as an ISO for tax purposes, including a requirement that the option must not be exercisable after 10 years of the date it was granted, the exercise price must not be less than the fair market value of the stock when the option is granted, and, subject to exceptions for transfers at death, the option is not transferable and may only be exercised by the holder. This last condition effectively eliminates gift and estate planning with ISOs.

There is no income tax when an ISO is granted to an employee. If specified holding period and employment qualifications under the Tax Code are met, there is no ordinary income tax when an ISO is exercised, and the employee acquires a basis in the stock in the amount paid to exercise the option. However, it is important to be aware that the alternative minimum tax will likely apply to the exercise of an ISO. The excess of the fair market value of the stock on the date of the exercise over the strike price (the spread) is ordinarily included in alternative minimum taxable income and, if you are over the AMT threshold (which can occur because of the inclusion of the ISO in your alternative minimum taxable income), AMT will be due. On a more positive note, any ISO related income is not subject to payroll withholding taxes – FICA or FUTA.

If the stock was held at least two years from the date the option was granted and one year after the stock was acquired pursuant to the exercise of the option, the sale of the stock will be subject to the familiar capital gain tax treatment; the taxpayer will recognize capital gain or loss determined by the difference between the sale price of the stock and its adjusted basis. If the preceding exercise of the option to acquire the stock was subject to the AMT, the basis in the stock is adjusted accordingly.

If the one-year and two-year holding periods related to the stock are not both met at the time of disposition (a disqualifying disposition), ordinary income is realized as of the date the option was exercised, and is recognized (meaning it is taxed), in the year of the disposition of the stock. In this circumstance, the sale of the stock acquired pursuant to the exercise of an ISO results in ordinary income on the spread (the compensation attributed to the exercise of the option) and any gain in excess of the compensation attributed to the exercise of the option is treated as capital gain.

In the event the stock declines materially in the calendar year of exercise of an ISO, it may make sense to sell the shares before year end and in essence trigger a disqualifying disposition. If an employee recognizes a loss in a disqualifying disposition, the compensation associated with the exercise of the option taxed as ordinary income will be limited to the excess of the amount realized on the disposition of the stock over the adjusted basis in the stock (typically the amount paid to exercise the option). And, if in the year of the exercise of an option there is a recognizable loss in a disqualifying disposition, the taxpayer’s alternative minimum taxable income will only be increased by the amount realized on the disposition over the adjusted basis of the stock, not the full amount of the excess of the fair market value of the stock on the date of exercise of the option over the exercise price. This allows the taxpayer to avoid paying AMT based on a higher share price if the stock declines in value after the exercise of the ISO.

As the complexity of this discussion indicates, planning, monitoring and timing are all important in managing the tax consequences of ISOs. Again, conferring with one’s tax advisors is highly recommended.

Non-qualified Stock Options
The other type of stock option is a non-qualified stock option. Non-qualified stock options are similar to ISOs in that the employee receives a right to purchase shares at a pre-determined price for a number of years, subject to a vesting schedule, but the taxation is a bit simpler, at least where these options have been designed by the employer to meet statutory exceptions to complex non-qualified deferred compensation rules. The following brief discussion relates to options that meet these regulatory exceptions.

There is ordinarily no tax at the time of the original grant of a non-qualified stock option unless the option has a readily ascertainable fair market value and is not subject to a substantial risk of forfeiture (which is not typical). If you were not taxed on the grant of a non-qualified stock option, you will be taxed upon the exercise of a non-qualified stock option unless the stock you acquire is subject to restrictions, in which case you will be taxed when the restrictions expire. Your income is compensation income in the amount of the excess of the fair market value of the shares you receive upon the exercise of the option over the grant price. This is ordinary income and is subject to payroll taxes (FICA and FUTA) and income tax. The income tax withholding requirement on the exercise of a non-qualified stock option can come as a surprise if not properly planned for. Taxes may be withheld from other compensation or you may need to sell stock and make the withholding payment to your employer.

Note also that you may make the same type of Code Section 83(b) election discussed above within 30 days of the grant of a non-qualified stock option. You will then be taxed in the year of the grant on the excess of the fair market value of the option (at the time of grant) over the amount paid (if any) for the option, but you will not be taxed upon exercise of the option. Any recognized appreciation after the grant is capital gain. However, if the non-qualified stock option is forfeited, no deduction is permitted. This makes Code Section 83(b) elections with these options fairly uncommon.

Whichever type of stock option you have, it is important to have a strategy for guiding your exercise plans. Employees are subject to blackout periods for quarterly earnings reports, and executives often have more days in the year when they cannot exercise their options than days when they can exercise them. By designing strategies which are intentional, you help minimize the emotional factors which can sometimes play too much of a role in decision making. Systematic exercises also help avoid forced activity just before expiration.

One interesting and potentially powerful planning strategy is to make gifts of non-qualified stock options (gifts of ISOs are not permitted) to family members or a trust for their benefit. This requires attention to many details, but can result in significant wealth transfer. Here’s a possible scenario where the option plan allows for transfers to family members:

  • Executive determines an amount of wealth she is comfortable transferring to a trust, and the trustee is able /willing to accept;
  • A third-party valuation of the options is obtained, which may be at a discount, but can be complicated, both in terms of determining the date of the completed gift, and its’ value;
  • The investment fiduciary of the trust determines an exercise price/strategy;
  • Exercise of the options results in ordinary income to the executive, and she must submit payment to her company for payroll taxes and income tax withholding promptly (she can use cash on hand or perhaps a temporary line of credit).

Since the employee is taxed when the option is exercised, the trust recognizes all the upside benefits of the options without the tax cost of the exercise. However, the executive needs to remain mindful of liquidity since the tax withholding payment is due within a few days of the exercise of the option, rather than as part of her quarterly estimated payments.

Bonus and incentive compensation are a welcome recognition of a job well done. But the receipt of the additional compensation is only part of the reward; the real power and value is in the butterfly effect of coupling bonus and incentive compensation with intentional planning to achieve your goals.

As a premier financial firm, Northern Trust specializes in life-driven wealth management backed by innovative technology and a strong fiduciary heritage. For 125 years we have remained true to the same key principles – service, expertise and integrity – that continue to guide us today. Our Wealth Planning Advisory Services team leverages our collective experience to provide financial planning, family education and governance, philanthropic advisory services, business owner services, tax strategy and wealth transfer services to our clients. It is our privilege to put our expertise and resources to work for you.

If you’d like to learn more, contact a Northern Trust professional at a location near you or visit us at northerntrust.com.

Northern Trust Wealth Planning Advisory Services include financial planning, family education and governance, philanthropic advisory services, tax strategy and wealth transfer services.
(c) 2015, Northern Trust Corporation. All rights reserved.
LEGAL, INVESTMENT AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel.
IRS CIRCULAR 230 NOTICE: To the extent that this communication or any attachment concerns tax matters, it is not intended to be used, and cannot be used by a taxpayer, for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see https://www.northerntrust.com/circular230.