Complex and varied, executive compensation packages require highly specialized understanding and advanced wealth planning strategies.
Along with the challenge of leading a company comes the responsibility of long-term wealth planning complicated by the nuance of an executive compensation plan. One of the greatest benefits available to you as an executive is equity-based compensation, which can be an extremely advantageous vehicle for wealth creation. Yet, each element of your compensation package demands highly specific wealth planning treatment. Take time to understand the wide-ranging attributes of these offerings and create effective strategies.
Below, we discuss several primary building blocks of executive compensation, including fixed-base salary and cash bonuses, equity-linked compensation, and non-qualified deferred compensation plans.
For a more in-depth discussion on the topics discussed here, including their associated tax treatments, read A Guide to Maximizing Corporate Executive Compensation.
Fixed-base Salary and Cash Bonus
By far, your salary and short-term incentives are likely to pale in comparison to the wealth you stand to acquire from long-term incentive programs and equity-based compensation. However, salary and short-term incentives are the most predictable aspects of your compensation plan, and neither rests on stock valuation or vesting. Although base compensation and bonuses do not necessarily require specialized planning, the key is to take advantage of the certainty they provide. Consider how best to utilize them for financial objectives:
Build cash reserves to establish liquidity in your portfolio
Pay off nondeductible debt
Minimize mortgage debt on your primary home or vacation property
Fund a 529 Plan for future education costs
Elect to defer a portion of compensation in your company’s deferred compensation plan
Pay the premium on an individual life insurance or disability income policy separate from your company
Establish a charitable gifting plan for the causes and organizations important to you
The majority of executive compensation is comprised of equity in the form of company stock, which exposes your portfolio to risk but also rewards you as the value of your company increases. For each of the offerings described below, be meticulous in your understanding of vesting periods, deliberate in your exercise strategy, aware of expiration dates and mindful of company retention guidelines.
Options provide the opportunity to participate in your company’s growth without placing personal wealth at risk. When granted an option, you have a right to purchase the stock at a predetermined price (strike price) for a defined period of time. Once the option vests, you then determine when to exercise that right. Two of the most common options are qualified incentive stock options and non-qualified stock options. The primary difference between the two is tax treatment with ISOs offering a potential tax benefit:
With ISOs, which are generally only available to executive management, there is no regular tax at grant, vesting or exercise (although there could be alternative minimum tax consequences). Upon disposition and given that holding requirement periods are met, the gain is taxed as long-term capital gain, which is usually lower than the income tax rate.
With non-qualified stock options, ordinary federal income tax, state income tax and payroll tax are due upon exercise.
Tracking and exercising your stock options
Exercising your stock options is one of the best ways to accumulate wealth, which often results in a concentrated equity position. The risk of holding a large concentrated equity position, however, is generally not in your favor — so it is essential to have a strategy to gradually reduce your holding.
Establishing a long-term plan based on your retirement date is one approach. Unfortunately, executives of public companies often do not have the luxury to exercise options at will and sell the resulting net shares, due to minimum holding requirements and public relations considerations.
A common strategy is to exercise options over time, selling enough shares with each exercise to pay the strike price, tax liability and transaction fees, yet holding a designated amount of net shares to demonstrate ongoing confidence in the company and satisfy the stock ownership requirements.
Restricted stock awards
Rather than provide an opportunity to purchase stock, a restricted stock award (RSA) grants stock subject to vesting – usually dependent on the continuation of employment or specified goals. Many public and private companies offer RSAs due to the strong retention characteristic nature of such grants.
RSA versus RSU
An RSA transfers the stock to the recipient on the date of grant, subject to specified vesting restrictions and conditions. RSAs come with voting rights immediately because the recipient actually owns the stock upon grant. This is in stark contrast to an RSU, which represents a right as opposed to ownership. An RSA cannot be redeemed for cash.
An RSU is not an actual transfer of stock on the grant date, but rather a commitment to transfer stock once specified vesting conditions are met. Additionally, some RSUs may be redeemed or settled for cash in lieu of stock.
One of the key considerations with RSAs is whether or not to make an IRS Section 83(b) election, which allows you to pay taxes on the stock at present value at the time of receipt. This can be advantageous from a tax perspective if you believe in the long-term value of the stock and are confident it will be vested. We illustrate the use of an 83(b) below.
Assume an executive is awarded restricted stock in 2020, which will vest in 2025.
At the time of the award the stock has a value of $200,000.
Upon vesting the stock has a value of $250,000.
The executive sells the stock in 2026 when it is valued at $350,000.
Executive pays $8,500 less in taxes by making an 83(b) election
If the executive makes a Section 83(b) election, the executive will pay ordinary income tax on $200,000 for the year of grant. Upon vesting, no tax is owed on the appreciation of $50,000. However, when the stock is sold, the executive will owe long-term capital gains tax on the entire stock appreciation in the amount of $150,000 ($350,000 fair market value at sale, less $200,000 cost basis).
No 83(b) election
If the executive decides not to make a Section 83(b) election, the executive will pay ordinary income tax on $250,000 – the value of the stock when it vests. When the stock is later sold, the executive will owe long-term capital gains tax on $100,000 ($350,000 fair market value at sale, less $250,000 cost basis).
Non-qualified Deferred Compensation Plans
A non-qualified deferred compensation plan is not a type of compensation, but a plan that allows you to earn your salary, bonus or any other compensation in one year and receive and pay income taxes in the future – typically during retirement when taxable income is expected to be lower. Many companies will also match a portion of the compensation deferred.
Because non-qualified deferred compensation plans are not subject to qualified plan regulation, they vary widely from company to company and can be specially customized to an executive.
A non-qualified deferred compensation plan can be a powerful tool to minimize tax while accumulating wealth, especially for executives who are maximizing 401(k) contributions. As a high income taxpayer, balance the benefits of tax-deferral against potential risks:
Since any income deferred remains an asset of your company, if your company endures financial distress you may suffer a loss because your company’s creditors may be first in line for payment.
Another challenge is that when you defer you are required to specify the date and manner in which you will receive payment. Although you may elect payment over a period of years or at retirement, you run the risk of needing the payments sooner and potentially incurring penalties to access your money.
Deferred compensation plans: postponing distribution
Although tax law prohibits distribution prior to the selected deferral date or any triggering event, you may subsequently postpone a distribution. To make such a change, the election of the new distribution date must be made at least 12 months before the original distribution date. Additionally, the new deferred distribution date must be at least five years after the original distribution date. Granted, the “redeferral” process may be a bit burdensome, but it might be worth the hassle to better serve future needs or further reduce tax liability.
Assume an executive scheduled a distribution for March 2021 to remodel their home. However, after their adult children moved to another state, they decided to purchase a vacation home in the same state to spend more time with grandchildren. The executive is required to establish a new distribution date prior to March 2020 to receive payment March 2026 or later.
Consider a different executive who, in December 2015, elected to receive a deferred income distribution in December 2020. Years later, the executive’s advisor shared that if a distribution period less than 10 years is selected, income will be sourced in the state earned. However, if the distribution period is 10 or more years, then each distribution will be subject to state tax in the state of domicile upon receipt. The executive recently decided to retire in a state that does not tax residents on income. The executive has until December 2019 to establish a new distribution date to receive payment December 2025 or later.